Accounts Receivable & Inventories
This article concerns the basic accounting principles for tracking accounts receivable and inventories, and how this relates to running an effective business. Whether the business entity is a small entrepreneurial enterprise or a large publicly traded corporation, maintaining sound accounting principles will help to ensure that the organization is well run and profitable. Both types of entities need to track business costs and maintain sufficient cash flows; and publicly traded corporations also need to ensure that their financial statements are accurate and in compliance with the Sarbanes-Oxley Act.
Keywords Accounts Receivable; Business Model; Cash Flow; Channel Stuffing; Compliance Officer; Controller; Defaulted Receivable; Delinquent Receivables; Factoring; Financial Statements; Generally Accepted Accounting Principles (GAAP); Inventories; Invoice; Just in Time (JIT); Sarbanes-Oxley Act (SOX); Securities Exchange Commission (SEC)
Finance: Accounts Receivable
Effectively tracking accounts receivable and inventories is a necessary condition for running a successful business enterprise. In short, both small business owners and officers of publicly traded companies need to know how much money is owed to the business for work it has performed or the goods, services and merchandise it has provided on a credit basis. This is the definition of accounts receivable.
Not only must business owners and executives have a system for tracking accounts receivable, they must also be able to track the goods, services and merchandise they can actually deliver, or its inventories. A company that does not maintain sufficient inventories will not be able to deliver these assets to customers, and this will be detrimental to customer relationships. On the other hand, if a company has inventories that cannot be sold, the costs incurred in maintaining those assets, that is the actual dollar cost of as well as the risks associated with warehousing goods while not having a market for them, will increase the business expenses and adversely affect the company's profit margin.
In order to keep track of accounts receivable, a company needs to establish a billing procedure. This will allow a customer to understand the terms of payment and give the company a method to keep accounts receivable current. The first step is for the company to provide the customer with an invoice and to have a system in place for tracking its invoices, such as a ledger.
Invoices should be prepared on a company's stationery and indicate the items that were purchased (or the goods and services that were provided), the date of the purchase, purchase price (including applicable taxes and delivery fees), delivery date, invoice date and terms of payment — that is the due date, payment amount and the means of payment. The latter includes cash on delivery, check, money order, and credit card, as well as electronic methods such as PayPal, Square, and Safaricom's M-Pesa.
Of course, sending an invoice by whatever means (e.g., mail, email, telecopy) may not guarantee payment. So there must also be a procedure to handle payments and late payments. Usually, a customer who fails to pay by the due date after they have been provided with an initial statement is notified by mail or email, and then a follow-up call is made. In the event payments are not made, third-party collection agencies can be utilized to collect overdue payments, and if payments are still not made, further legal action may be required. One way to mitigate late payments is to have fewer payment terms; in particular, payments should be made in full by a certain date, and a penalty should be applied to late payments.
For accounting purposes on income and financial statements, and in accordance with Generally Accepted Accounting Principles (GAAP), accounts receivable are listed as assets even though the cash is not on hand. Further, the cost of providing credit to customers is also a significant element in determining a company's working capital. A company's working capital is determined by cash flows, that is, an entity's cash receipts less its disbursements for a specific time period. Ultimately, a successful enterprise is one that has sufficient cash flows that will generate profits. Effective management of working capital will not only improve a company's profits but also reduce the risk of uncollected or delinquent receivables.
One way to enhance cash flow is to quickly collect accounts receivable by simplifying the invoicing process, minimizing payment terms, and having a collections procedure in place for delinquent accounts. Even if all these mechanisms are in place, a company still can experience problems collecting receivables and thus run into cash flow shortages. However, there is a means to mitigate the risk of late, uncollected or defaulted receivables, called factoring.
Basically, factoring is the outright sale of a firm's account receivables to a third party. At one time, factoring was not viewed favorably; however, it is now a widely accepted and customary business practice. According to Feast (2013), research company BDRC reported that the use of such external financing as asset-based lending, invoice discounting, and factoring by UK small businesses increased to 21% in the second quarter of 2013, up from 15% in prior quarters.
But more importantly, it is good business management that enables a company to have sufficient working capital.
Factoring is usually made on a non-recourse basis. This means that the third party to whom the receivables are sold (the "factor"), is solely responsible for collection of the receivables. In so doing, the factor also assumes the risk of uncollected or defaulted receivables. To offset this risk, the sale of the receivables is usually made at a discount of the account's value. There are other forms of factoring, such as "recourse factoring" and "invoice discounting."
In short, factoring will enhance cash flows since payment of invoices becomes immediate. Ultimately, efficient cash flow will enhance a company's ability to re-invest in the company as well as to invest in interest-bearing investments. Effectively tracking accounts receivable is one tool for managing working capital that can enhance profits.
Another essential component of managing working capital is the effective management of inventory. This is a complex but necessary task since excess inventory (like uncollected or defaulted receivables) can adversely affect cash flows. At the same time, insufficient inventories can result in lost sales and delays for customers — and if such delays become a pattern, customers will seek out a company that can provide goods and services expediently. Not only will this affect a company's profits, but lost sales and lost customers can also have a significant adverse impact on a company's professional reputation — a bad name is bad for business.
One key to effectively managing inventory is to know how quickly stock is moving, and this can vary depending on the type and size of the business. Today, for example, many large manufacturing companies utilize a Just-in-Time method for maintaining inventories (JIT). This means that all the components of the good being manufactured on a particular day are delivered early that morning — no earlier or later (Flanagan 2005).
JIT inventorying reduces manufacturing costs since JIT stocks take up little space and this reduces the need for warehousing. Supplies that remain warehoused for excessive periods of time have a greater propensity for being damaged, and in some cases such supplies can become obsolete, and there is no market for obsolete goods. The key for a company is to determine which supplies move quickly and which move slowly. Inventory that does not move quickly means that cash flow will be hindered.
Although the JIT method reduces manufacturing costs, it should be noted that profitability ratios (such as return on assets, return on equity, and basic earning power) that aggregate all of a firm's activities may not be suitable metrics to determine the effect of JIT and lean manufacturing methods on a firm's financial performance (Klingenberg, Timberlake,...
(The entire section is 3706 words.)