Chapter One : Background literature
1.1 – Account Receivable(AR)
(AR and Management Policy: Theory and Evidence – Shehzad L. Mian & Clifford W. Smith, Jr)
The basis of my subject “Bad debt expense estimation model” stems from account receivable. Account receivable is the term used by companies to describe money owed to them by clients or customers for goods and services provided. Bad debt expense is that portion of account receivables that will not be collected. Therefore, without any receivables a company will not have bad debts, thus no need to estimate any bad debt expense.
Business to business transactions are mostly done with a promise to pay for goods and services provided at a later date. When a company sells its products or provides its services to other businesses or even individuals, it expects payment for the products or services. In most cases, these payments are not done immediately. The company then expects payment at some future date. This promise to pay becomes a receivable to the company providing the goods or services. Thus, the customer goes into a legal obligation to transfer cash to the company at some future date. Receivables form a large part of most company’s assets. Going through the balance sheet of every company, one would come across account receivables registered as an asset to the company. Financial and management accounting cannot over emphasize the importance of account receivable in every organization.
Being an asset, account receivable management has gained momentum in recent years in organizations and financial institutions. Since receivables ultimately stem from extending credits to customers, the issue of who to extend credits to and by how much cannot be stressed enough. It might not always be the case, but companies want to grant credit to other companies that are financially sound in order to have a greater degree of certainty that payment will be received in the future. Thus, it becomes absolutely important to grade companies and even financial institutions with regards to their payment behaviors. Companies definitely do not want to write off a big part of their assets at the end of the year as bad debt expense.
Generally, there are two main types of trade account receivable. -
Past due AR
Current AR are debts that have not yet exceeded the amount of time allocated for the debt to be paid as agreed upon by the creditor and the debtor. In most cases, the length of time for the payment of a debt ranges from ten(10) to as long as ninety(90) days and even to a year in rear cases. This length of time could be longer for specific debts like notes receivable(loan related) issued by companies.
Past due debts are those that have not been paid within the agreed payment term. These are the ones that mostly draw the attention of managers and credit professionals. This is because, the longer a debt is past due, the greater the chances of a debtor defaulting on the payment of the debt.
Managing account receivable has always been a daunting task for managers and other finance professionals. Each organization has its unique operating characteristics and this also calls for different techniques and ways of managing AR. Nonetheless, the foundation behind AR is the policy and procedure for granting credit of the organization. Most organizations obviously want to increase their sales, but the policies they use to assess clients to whom they extend credit will ultimately determine the size of their receivables and to a greater extent, the size of the allowance for bad debt and bad debt expense. Thus, the credit policies an organization uses will determine the amount of receivables which they need to achieve at any given time. A credit policy is a key financial management guideline that should be prepared under the guidance of top finance managers and accountants. It should incorporate the company’s goal, the criteria and timetable of achieving these goals as...
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