Question

When a company lets customers buy on credit, the company attracts more customers. Allowing sales on credit is a part of doing business. However, it is not without risk! The result may be attracting some customers who will never pay the amount they owe to the business. When this money is not paid, the business has an uncollectible account which must be written-off. If a business has too many uncollectible accounts, the business suffers and the end result can spell disaster!

There are two methods of writing off uncollectible accounts:

The Allowance Method (recognized by GAAP)

The Direct Write-off Method (not recognized by GAAP)

There are several different allowance methods:

Percentage of Sales Method – also referred to as the Income Statement Method

Percentage of Accounts Receivables Method – also referred to as the Balance Sheet Method

Aging of Receivables Method

The difference between the Percentage of Sales Method and the Percentage of Accounts Receivables Method is how the allowance for doubtful accounts is treated when using the two methods.

Accounts receivable are amounts due from customers for credit sales. For a company selling on credit, it is important to assess both the quality and liquidity of its accounts receivable. The quality of accounts receivable is how likely you are to collect these accounts without any loss. The speed of collection, or how fast these accounts are paid or converted to cash, relates to the liquidity of collection. The accounts receivable turnover measures both the quality and liquidity of accounts receivable. In other words, it measures how likely collections are going to be and the speed of those collections.

Instructions

Imagine you own a business that sells to customers on trade credit. For example, you manufacture luxury soaps and you sell these soaps to boutique stores in your hometown area.

1. How would you manage the collection of receivables?

2. Even with careful planning, sometimes receivables become uncollectible. Which method would you use to write off an uncollectible account? Explain your reasons.

3. What procedures would you put into place to encourage customers to pay their bills on time?

Please answer all of the questions, if you can not answer all of the questions do not reply.

Answer 1

How would you manage the collection of receivables?

In order to manage the collection of receivables, following procedure must be adopted:-

1. Aging of accounts must be done to manage the overdue accounts. Aging of accounts classify the accounts on the basis of age or period since which it is not paid. The older accounts from which no payment is received are analyzed and then action is taken to recover it
2. Prior period notice must be sent just before the due date of the collection of receivables.
3. Steps to negotiate settlement payments must be taken in order to settle or recover payments from accounts receivables
4. In order to speed up cash flows, factoring of receivables must be done. This will help to collect cash flows from receivables on time.
5. Proper credit policy must be set. Management of receivables becomes easier with well established credit policy.

Even with careful planning, sometimes receivables still become uncollectible. Which method would you use to write off an uncollectible account? Explain your reasons.

Two methods are basically suggested to write off an uncollectible account. These are:-

1. Direct write off method. - Under this method, accounts receivables are written off wholly. The lump sum amount is charged and written off as uncollectible or once it becomes uncollectible.

1. Allowance method: - Under allowance method, provision equal to the amount uncollectible is made in the books of accounts and then thereafter.

What procedures would you put into place to encourage customers to pay their bills on time?

In order to encourage customers to pay bill on time following procedures must be adopted:-

1. Discount must be given to encourage prompt payment. Additional discount can also be offered if cash is paid before the specified period of time.
2. Send reminders before the due date of payment
3. All forms of payment must be encouraged
4. Payment policies must be made clear.
5. Deposit in advance system can also be implemented. This will ensure collection of a portion of amount well in advance.