What Is Accounts Receivable Aging?

Accounts receivable aging is a periodic report that categorizes a company’s accounts receivable according to the length of time an invoice has been outstanding. It is used as a gauge to determine the financial health and reliability of a company’s customers.

If the accounts receivable aging shows a company’s receivables are being collected much more slowly than normal, this is a warning sign that business may be slowing down or that the company is taking greater credit risk in its sales practices.

How Accounts Receivable Aging Works

Accounts receivable aging, as a management tool, can indicate that certain customers are becoming credit risks, and may reveal whether the company should keep doing business with customers that are chronically late payers. 

Accounts receivable aging has columns that are typically broken into date ranges of 30 days each and shows the total receivables that are currently due, as well as those that are past due for each 30-day time period.

Allowance for Doubtful Accounts

Accounts receivable aging is useful in determining the allowance for doubtful accounts. When estimating the amount of bad debt to report on a company’s financial statements, the accounts receivable aging report is useful to estimate the total amount to be written off.

The primary useful feature is the aggregation of receivables based on the length of time the invoice has been past due. Accounts that are more than six months old are unlikely to be collected, except through collections or a court judgment.

Companies apply a fixed percentage of default to each date range. Invoices that have been past due for longer periods of time are given a higher percentage due to increasing default risk and decreasing collectibility. The sum of the products from each outstanding date range provides an estimate regarding the total of uncollectible receivables.

Aged Receivables Report

The aged receivables report is a table that provides details of specific receivables based on age. The specific receivables are aggregated at the bottom of the table to display the total receivables of a company, based on the number of days the invoice is past due.

The typical column headers include 30-day windows of time, and the rows represent the receivables of each customer. Here’s an example of an accounts receivable aging report.

What Is an Allowance for Bad Debt?

An allowance for bad debt is a valuation account used to estimate the amount of a firm’s receivables that may ultimately be uncollectible. It is also known as an allowance for doubtful accounts. When a borrower defaults on a loan, the allowance for bad debt account and the loan receivable balance are both reduced for the book value of the loan.

How an Allowance for Bad Debt Works

Lenders use an allowance for bad debt because the face value of a firm’s total accounts receivable is not the actual balance that is ultimately collected. Ultimately, a portion of the receivables will not be paid. When a customer never pays the principal or interest amount due on a receivable, the business must eventually write it off entirely.

Methods of Estimating an Allowance for Bad Debt

There are two primary ways to calculate the allowance for bad debt. One method is based on sales, while the other is based on accounts receivable.

Sales Method

The sales method estimates the bad debt allowance as a percentage of credit sales as they occur. Suppose that a firm makes $1,000,000 in credit sales but knows from experience that 1.5% never pay. Then, the sales method estimate of the allowance for bad debt would be $15,000.

Accounts Receivable Method

The accounts receivable method is considerably more sophisticated and takes advantage of the aging of receivables to provide better estimates of the allowance for bad debts. The basic idea is that the longer a debt goes unpaid, the more likely it is that the debt will never pay. In this case, perhaps only 1% of initial sales would be added to the allowance for bad debt.

However, 10% of receivables that had not paid after 30 days might be added to the allowance for bad debt. After 90 days, it could rise to 50%. Finally, the debts might be written off after one year.

Requirements for an Allowance for Bad Debt

According to generally accepted accounting principles (GAAP), the main requirement for an allowance for bad debt is that it accurately reflects the firm’s collections history. If $2,100 out of $100,000 in credit sales did not pay last year, then 2.1% is a suitable sales method estimate of the allowance for bad debt this year. This estimation process is easy when the firm has been operating for a few years. New businesses must use industry averages, rules of thumb, or numbers from another business.

Default Considerations

When a lender confirms that a specific loan balance is in default, the company reduces the allowance for doubtful accounts balance. It also reduces the loan receivable balance, because the loan default is no longer simply part of a bad debt estimate.

Adjustment Considerations

The allowance for bad debt always reflects the current balance of loans that are expected to default, and the balance is adjusted over time to show that balance. Suppose that a lender estimates $2 million of the loan balance is at risk of default, and the allowance account already has a $1 million balance. Then, the adjusting entry to bad debt expense and the increase to the allowance account is an additional $1 million.

What Is an Average Collection Period?

Average collection period refers to the amount of time it takes for a business to receive payments owed by its clients in terms of accounts receivable (AR). Companies use the average collection period to make sure they have enough cash on hand to meet their financial obligations. The average collection period is an indicator of the effectiveness of a firm’s AR management practices and is an important metric for companies that rely heavily on receivables for their cash flows.

How Average Collection Periods Work

Accounts receivable is a business term used to describe money that entities owe to a company when they purchase goods and/or services. Companies normally make these sales to their customers on credit. AR is listed on corporations’ balance sheets as current assets and measures their liquidity. As such, they indicate their ability to pay off their short-term debts without the need to rely on additional cash flows.

The average collection period is an accounting metric used to represent the average number of days between a credit sale date and the date when the purchaser remits payment. A company’s average collection period is indicative of the effectiveness of its AR management practices. Businesses must be able to manage their average collection period to operate smoothly.

A lower average collection period is generally more favorable than a higher one. A low average collection period indicates that the organization collects payments faster. However, this may mean that the company’s credit terms are too strict. Customers who don’t find their creditors’ terms very friendly may choose to seek suppliers or service providers with more lenient payment terms.

Formula for Average Collection Period

Average collection period is calculated by dividing a company’s average accounts receivable balance by its net credit sales for a specific period, then multiplying the quotient by 365 days.

Average Collection Period = 365 Days * (Average Accounts Receivables / Net Credit Sales)

Alternatively and more commonly, the average collection period is denoted as the number of days of a period divided by the receivables turnover ratio. The formula below is also used referred to as the days sales receivable ratio.

Average Collection Period = 365 Days / Receivables Turnover Ratio

The average receivables turnover is simply the average accounts receivable balance divided by net credit sales; the formula below is simply a more concise way of writing the formula.

Average Accounts Receivables

For the formulas above, average accounts receivable is calculated by taking the average of the beginning and ending balances of a given period. More sophisticated accounting reporting tools may be able to automate a company’s average accounts receivable over a given period by factoring in daily ending balances.

When analyzing average collection period, be mindful of the seasonality of the accounts receivable balances. For example, analyzing a peak month to a slow month by result in a very inconsistent average accounts receivable balance that may skew the calculated amount.

Net Credit Sales

Average collection period also relies on net credit sales for a period. This metric should exclude cash sales (as those are not made on credit and therefore do not have a collection period).

In addition to being limited to only credit sales, net credit sales exclude residual transactions that impact and often reduce sales amounts. This includes any discounts awarded to customers, product recalls or returns, or items re-issued under warranty.

Importance of Average Collection Period

Average collection period boils down to a single number; however, it has many different uses and communicates a variety of important information.

• It tells how efficiently debts are collected. This is important because a credit sale is not fully completed until the company has been paid. Until cash has been collected, a company is yet to reap the full benefit of the transaction.
• It tells how strict credit terms are. This is important as strict credit terms may scare clients away; on the other hand, credit terms that are too loose may attract customers looking to take advantage of lenient payment terms.
• It tells how competitors are performing. This is important because all figures needed to calculate the average collection period are available for public companies. This gives deeper insight into what other companies are doing and how a company’s operations compare.
• It tells early signals of bad allowances. This is important because as the average collection period increases, more clients are taking longer to pay. This metric can be used to signal to management to review its outstanding receivables at risk of being uncollected to ensure clients are being monitored and communicated with.
• It tells of a company’s short-term financial health. This is important because without cash collections, a company will go insolvent and lack the liquidity to pay its short-term bills.

How to Use Average Collection Period

The average collection period does not hold much value as a stand-alone figure. Instead, you can get more out of its value by using it as a comparative tool.

The best way that a company can benefit is by consistently calculating its average collection period and using it over time to search for trends within its own business. The average collection period may also be used to compare one company with its competitors, either individually or grouped together. Similar companies should produce similar financial metrics, so the average collection period can be used as a benchmark against another company’s performance.

Companies may also compare the average collection period with the credit terms extended to customers. For example, an average collection period of 25 days isn’t as concerning if invoices are issued with a net 30 due date. However, an ongoing evaluation of the outstanding collection period directly affects the organization’s cash flows.

Example of Average Collection Period

As noted above, the average collection period is calculated by dividing the average balance of AR by total net credit sales for the period, then multiplying the quotient by the number of days in the period.

Let’s say a company has an average AR balance for the year of $10,000. The total net sales that the company recorded during this period was $100,000. We would use the following average collection period formula to calculate the period:

($10,000 ÷ $100,000) × 365 = Average Collection Period

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The average collection period, therefore, would be 36.5 days. This is not a bad figure, considering most companies collect within 30 days. Collecting its receivables in a relatively short and reasonable period of time gives the company time to pay off its obligations.

If this company’s average collection period was longer—say, more than 60 days— then it would need to adopt a more aggressive collection policy to shorten that time frame. Otherwise, it may find itself falling short when it comes to paying its own debts.

Accounts Receivable (AR) Turnover

The average collection period is closely related to the accounts turnover ratio, which is calculated by dividing total net sales by the average AR balance.

Using the previous example, the AR turnover is 10 ($100,000 ÷ $10,000). The average collection period can also be calculated by dividing the number of days in the period by the AR turnover. In this example, the average collection period is the same as before: 36.5 days.

365 days ÷ 10 = Average Collection Period

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Collections by Industries

Not all businesses deal with credit and cash in the same way. Although cash on hand is important to every business, some rely more on their cash flow than others.

For example, the banking sector relies heavily on receivables because of the loans and mortgages that it offers to consumers. As it relies on income generated from these products, banks must have a short turnaround time for receivables. If they have lax collection procedures and policies in place, then income would drop, causing financial harm.

Real estate and construction companies also rely on steady cash flows to pay for labor, services, and supplies. These industries don’t necessarily generate income as readily as banks, so it’s important that those working in these industries bill at appropriate intervals, as sales and construction take time and may be subject to delays.

The Bottom Line

The average collection period is the average number of days it takes for a credit sale to be collected. During this period, the company is awarding its customer a very short-term “loan”; the sooner the client can collect the loan, the earlier it will have the capital to use to grow its company or pay its invoices. While a shorter average collection period is often better, too strict of credit terms may scare customers away.

What Are Accruals?

Accruals are revenues earned or expenses incurred that impact a company’s net income on the income statement, although cash related to the transaction has not yet changed hands. Accruals also affect the balance sheet, as they involve non-cash assets and liabilities.

For example, if a company has performed a service for a customer, but has not yet received payment, the revenue from that service would be recorded as an accrual in the company’s financial statements. This ensures that the company’s financial statements accurately reflect its true financial position, even if it has not yet received payment for all of the services it has provided.

Accrual accounts include, among many others, accounts payable, accounts receivable, accrued tax liabilities, and accrued interest earned or payable.

Understanding Accruals

An accrual is a record of revenue or expenses that have been earned or incurred, but have not yet been recorded in the company’s financial statements. This can include things like unpaid invoices for services provided, or expenses that have been incurred but not yet paid. Accruals are important because they help to ensure that a company’s financial statements accurately reflect its true financial position, even if it has not yet received payment for all of the services it has provided or paid all of its bills.

In accrual-based accounting, revenue is recognized when it is earned, regardless of when the payment is received. This means that if a company provides a service to a customer in December, but does not receive payment until January of the following year, the revenue from that service would be recorded in December, when it was earned. Similarly, expenses are recorded when they are incurred, regardless of when they are paid. For example, if a company incurs expenses in December for a service that will be received in January, the expenses would be recorded in December, when they were incurred.

The Accrual Method of Accounting

Accruals and deferrals are the basis of the accrual method of accounting, the preferred method by generally accepted accounting principles (GAAP). Using the accrual method, an accountant makes adjustments for revenue that has been earned but is not yet recorded in the general ledger and expenses that have been incurred but are also not yet recorded. The accruals are made via adjusting journal entries at the end of each accounting period, so the reported financial statements can be inclusive of these amounts.

The use of accrual accounts greatly improves the quality of information on financial statements. Before the use of accruals, accountants only recorded cash transactions. Unfortunately, cash transactions don’t give information about other important business activities, such as revenue based on credit extended to customers or a company’s future liabilities. By recording accruals, a company can measure what it owes in the short-term and also what cash revenue it expects to receive. It also allows a company to record assets that do not have a cash value, such as goodwill.

In double-entry bookkeeping, the offset to an accrued expense is an accrued liability account, which appears on the balance sheet. The offset to accrued revenue is an accrued asset account, which also appears on the balance sheet. Therefore, an adjusting journal entry for an accrual will impact both the balance sheet and the income statement.

Recording Accruals on the Income Statement and Balance Sheet

To record accruals on the balance sheet, the company will need to make journal entries to reflect the revenues and expenses that have been earned or incurred, but not yet recorded. For example, if the company has provided a service to a customer but has not yet received payment, it would make a journal entry to record the revenue from that service as an accrual. This would involve debiting the “accounts receivable” account and crediting the “revenue” account on the income statement.

On the other hand, if the company has incurred expenses but has not yet paid them, it would make a journal entry to record the expenses as an accrual. This would involve debiting the “expenses” account on the income statement and crediting the “accounts payable” account.

Examples of Accruals

Let’s look at an example of a revenue accrual for a utility company.

Accounts Payable

An example of an accrued expense for accounts payable f could be the cost of electricity that the utility company has used to power its operations, but has not yet paid for. In this case, the utility company would make a journal entry to record the cost of the electricity as an accrued expense. This would involve debiting the “expense” account and crediting the “accounts payable” account. The effect of this journal entry would be to increase the utility company’s expenses on the income statement, and to increase its accounts payable on the balance sheet.

Another example of an expense accrual involves employee bonuses that were earned in 2019, but will not be paid until 2020. The 2019 financial statements need to reflect the bonus expense earned by employees in 2019 as well as the bonus liability the company plans to pay out. Therefore, prior to issuing the 2019 financial statements, an adjusting journal entry records this accrual with a debit to an expense account and a credit to a liability account. Once the payment has been made in the new year, the liability account will be decreased through a debit, and the cash account will be reduced through a credit.

Accounts Receivable

The utility company generated electricity that customers received in December. However, the utility company does not bill the electric customers until the following month when the meters have been read. To have the proper revenue figure for the year on the utility’s financial statements, the company needs to complete an adjusting journal entry to report the revenue that was earned in December.

It will additionally be reflected in the receivables account as of December 31, because the utility company has fulfilled its obligations to its customers in earning the revenue at that point. The adjusting journal entry for December would include a debit to accounts receivable and a credit to a revenue account. The following month, when the cash is received, the company would record a credit to decrease accounts receivable and a debit to increase cash.

Accrued Interest

Another expense accrual occurs for interest. For example, a company with a bond will accrue interest expense on its monthly financial statements, although interest on bonds is typically paid semi-annually. The interest expense recorded in an adjusting journal entry will be the amount that has accrued as of the financial statement date. A corresponding interest liability will be recorded on the balance sheet.

The Bottom Line

Accruals impact a company’s bottom line, although cash has not yet exchanged hands. The accrual method of accounting is the preferred method according to GAAP, and involves making adjustments for revenue that has been earned but is not yet recorded, and expenses that have been incurred but are not yet recorded, by making adjusting journal entries at the end of the accounting period. Accruals are important because they help to ensure that a company’s financial statements accurately reflect its actual financial position.