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Archives: Credit & Collections Management

Accounts Receivables and Sarbanes Oxley/Bill 198 Compliance

Financial Controls for Accounts Receivable

For most companies, Accounts Receivable is the largest or second-largest asset on their balance sheet. Therefore, any weakness in the financial controls for Accounts Receivable could have a serious impact on the company’s financial statements. Since Accounts Receivable departments interact with almost every other department in the company, the Accounts Receivable processes affect almost every process in the company. Weak controls can lead to increased risk in many other areas.

The Sales Contract

Every Account Receivable is a result of a sale. Accounts Receivable employees are in the business of converting Accounts Receivable into Cash. In order to be truly an Account Receivable, the sale must be based on a valid sales contract. Every sale must be based on a sales contract, whether it is the same sales agreement for all customers, or whether a unique contract has been drawn up for a particular sale.

Collecting Before You Sell

The collection process should start even before the sale is made, even before the sales department goes after a particular customer. Accounts Receivable processes can reduce the risk of dealing with a particular customer by pre-qualifying customers as much as possible.

It is better to not make the sale than to make a sale that you cannot collect. For example, if your profit on a particular item is 5% and you cannot collect then you are much worse off than if you hadn’t made the sale. If the sale price is $100, and the profit is 5 %, than the company makes $5. However, if the sale is on credit and the Account Receivable amount of $100 is written off to bad debt, then it takes 20 additional sales or $2000 to recover the $100 write-off. Every process in Accounts Receivable that prevents a write-off in a 5% profit margin environment is equal to 20 sales. Accounts Receivable processes that work well are extremely valuable.

Accounts Receivable should be involved in the drawing up of the sales agreement because this document will have a serious impact on the company’s ability to collect, and ultimately a serious impact on the company’s financial statement.

Controlling the documentation received from the customer is critical to successfully converting Accounts Receivable to cash and avoiding having to write off bad debts. Weak controls in this area can have a serious impact. The controls need to work because the risk of not following through and producing a misstatement can be high. For example, shipping products to a customer without first obtaining the proper approvals for the sales contract can mean that the company will not get paid. If the contract was thought to provide security in case of non-payment, but if someone who was supposed to review the deal did not catch a defect in the document, those Accounts Receivable dollars may be in jeopardy. As a result, a reserve for doubtful accounts needs to be established for the Account Receivable, thus reducing profits substantially. If not, the Accounts Receivable figure will be overstated and the company’s financial statements will contain a material misstatement.

Terms

Accounts Receivable payment terms need to be clearly spelled out. The Accounts Receivable financial controls need to be able to catch all deviations from the established processes. They also need to spell out the approval process, including who has the authority to approve credit. Sales should never have the final say in approving credit. Their input is always welcome, but the authority and responsibility for approving credit should reside inside the credit department. Controls within the company have to prevent unauthorized shipments (not credit approved) to customers. For example, shipping on consignment terms instead of open terms requires different documentation and processes. Financial controls have to be in place to reduce the risk of an error in documentation. The financial statements must reflect the true risk of the particular Account Receivable. The company should not report the Account Receivable as if it were able to collect it when in fact a defective document may prove to be worthless when it comes time to enforce collection.

Sales Returns

The process of recording customer sales returns of inventory needs to be included in the Accounts Receivable financial controls. When a customer returns goods, the inventory needs to be recorded back into the company’s balance sheet. At the same time, a credit note should be issued to reduce the amount collectible from the customer. Controls need to ensure that the company is not carrying on its books Accounts Receivable that is not waiting to be collected, but instead is waiting to be eliminated by a credit note to the customer’s account.

Companies often have poor controls in this area. If sales or customer service departments are responsible for issuing credit notes, they will often drag their feet because the sales activities have a higher priority, or they may simply not want to reduce their sales figure until after month end or year-end.

The amount of the credit note issued may actually be more or it may be less than anticipated. For example, because there may be clauses in the sales agreement that stipulate that the company, not the customer, will pay for shipping charges, the credit will be more. On the other hand, the sales agreement may say that the company can charge a “restocking fee” when material is returned, which will reduce the amount of the credit note.

Each clause in the sales agreement needs to be examined and the risk associated with it evaluated and controls put in place to reduce that risk.

Companies need to strengthen their financial controls to ensure that Accounts Receivable is not materially overstated because of pending sales return credit notes.

Interest

If the financial controls over Accounts Receivable are weak, then the controls over the process of charging interest to overdue customers may also be weak. Since interest is based on the interest provision of the original sales agreement, financial controls must ensure that overdue interest is charged according to the contract. For example, one customer may be given 60 days to pay while another may have to pay in 30 days. Charging interest on all overdue customer accounts that are over 30 days old would not be correct. The amount of interest recorded in the financial statements would not reflect the company’s legal right to collect that interest. Financial controls need to make sure that every dollar of interest on the books is justified.

The Collection Process

The collection process itself needs to be tightly controlled. Obviously, if some of the Accounts Receivable staff does not follow the established process for collecting accounts, they may not collect some of the company’s money and significant amounts may have to be written off. Controls need to be in place that reduces risk by ensuring that collectors follow established collection policy.

There is more risk than most people are aware of in the collection process. If the management controls for the process itself are weak, the way collectors do their job could mean that rather than collecting money, the company may be at risk of being fined or sued from following unscrupulous, if not downright illegal, collection practices. For example, if the collection staff is taking a customer to court in attempt to collect, they company may end up being sued by the customer if it is a frivolous suit. An obvious and simple control would be to require prior approval by management before this step is taken. Not only would it reduce the risk of a counter-suit, but also it would eliminate unnecessary costs and frustration. Financial controls that require the proper management approvals will prevent things from getting that far.

Collecting from consumers is very different from collecting from businesses. The laws governing collection action and deadlines, security and privacy are different. Companies need to have financial controls to make sure that all legal requirements are met and that opportunities for collection are not lost because of weak controls.

Time-Sensitive Documents

Financial controls of time-sensitive documents used as collateral are critical because the huge impact they may have on the company’s financial statements. For example, if the company is counting on a letter of credit to back up their decision to grant credit, a collector who does not follow the process may lose the chance to collect the money if he or she does not act before the letter of credit expires. Another example is losing lien rights because someone forgot to renew it before the expiry date.

Setting Credit Limits

Setting the proper credit limits is critical to good Accounts Receivable management. The criteria used to set limits, the investigative process, and the approval limit hierarchy must be clearly spelled out in the Accounts Receivable financial controls, which should include a written credit policy.

This area requires special attention because the setting of credit limits should be very deliberate. Choosing the correct limit should be a result of following a clearly proscribed process that should be easily followed and the result easily duplicated. For example, if two different credit analysts were to work independently on setting a credit limit using exactly the same information, they should arrive at the same recommendation, within a narrow range, if they follow the same process. Controls should ensure that analysts would consistently arrive at the same result.

Another control that companies use is to have credit approval limits for each member of the credit department. The greater the risk (the more money involved), the higher up the chain of command that is required. For example, a credit analyst may be able to approve limits up to $50,000, the credit manager up to $100,000, the VP Finance up to $500,000 and the CEO must approve all limits above $500,000.

Credit Scoring

The advent of credit scoring to speed up the credit approval process has a built in risk that needs to be assed and carefully controlled. The use of these models means sacrificing individual assessments that may take more time and be more costly. The benefit of faster response time in a competitive environment may be cost effective for companies who increase their profits by more than the amount of bad debt they will write off using this system. However, a strong control and monitoring process coupled with a continual testing of the underlying assumptions of the scoring model is needed to assure the company that the risks are being controlled adequately. For example, the model might assume that all customers who have been in business at least ten years should be scored higher than those that have been in business a shorter time. The test is how old are the businesses whose accounts get written off. If how long they have been in business does not seem to be a factor, then the model and the risk associated with it need to be reassessed.

Outsourcing

Companies that outsource any of the Credit and Accounts Receivable functions need to set up strong financial controls to ensure that the outsource companies actually do what they promise to do. For example, if the credit application process involves sending the electronic application form out to a third party to do preliminary, routine verifications of the corporate name and banking information, there is a risk that these companies may not do a thorough job in all cases. This risk must be evaluated and controlled so that the company knows whom they are dealing with. A small error here could mean an inability to collect because the invoices are invoiced to the wrong company, and the assets that were thought to be available in case of a collection problem actually belong to another corporation.

Collection Agencies

Sending accounts to collection agencies requires that someone monitor their efforts.

Strong financial controls here can retrieve cash that would not have come in if the collection agencies were not being monitored. For example, if they can get away with it, collection agencies will only work larger accounts because they are paid a commission (usually a third to a half) of the amount they collect. Therefore, they tend to work large accounts and leave the smaller ones for later. Letting the collection agencies get away with this means letting your smaller accounts get old and are less likely to be collected as time goes on. Collection agencies will be less inclined to try this if they know that you have controls to monitor their performance. Stay on top of the situation and demand that they work both large and small accounts. The process needs to be documented, examined, and the risk associated with it evaluated and controlled. Your monitoring will reveal if you are not getting the performance that you demand from the collection agency and you will know when it is time to move the accounts.

Monitoring Customer Creditworthiness

Controls need to be in place to monitor on an ongoing basis the creditworthiness of customers. The process has to be clearly proactive to get ahead of any deterioration in a customer’s ability to pay their bills on time. Otherwise waiting for the moment when the customer cannot pay will lead to a high risk of never getting paid.

Criteria need to be established to alert staff to begin a credit investigation. Other than a late payment, triggers for an investigation before their regular review can be any change in pattern such as an increase in deductions, a number of excuses for delays in payments, asking for copies of invoices to delay payment, calls not being returned and, of course, the old standby that the person who needs to approve the payment is away.

If there is no process established to manage this risk, the controls are weak and this is an area where Management must disclose in its report this weakness in their financial controls.

Controls for the Acceptance of Collateral

When collateral is required to approve credit, such as a stand-by letter of credit, financial controls should ensure that the documentation is valid before shipping to a customer or providing a service. For example, the controls may require that the credit department obtain a sign-off from the legal department to make sure the document can be relied upon if it becomes necessary to use the letter of credit to collect. It may also say that the Treasury Department must approve the choice of financial institutions on which the letter of credit is drawn. Weak controls could produce of substantial risk of not being able to collect and a huge impact on the company’s financial statement.

Bad Debt Allowance

The allowance for bad debt is an account that needs strong financial controls. The approval process along with the criteria for inclusion is a process that can lend itself to manipulation if it is not tightly controlled.

Too many companies use this account to even out bumps in the income statement from quarter to quarter. Companies will “pad” the bad debt allowance account in good years and pull it back in lean years.

This is a poor practice because the amount of the allowance should be a reflection of the level of “collectibility” of Accounts Receivable. The goal is to state Accounts Receivable at its “net realizable value.” In other words, it should be the amount of cash the company is expected to actually collect. Otherwise, the allowance is wrong and the expense will cause the profit number to be wrong. The company will also have to report this control weakness on their annual report in order to be Sarbanes-Oxley compliant.

Write-offs

As much as Accounts Receivable people try to avoid them, bad debt write-offs are a part of doing business on credit terms. Financial controls need to be in place that set out the process for identifying, documenting, and approving bad debt write-offs. Look at every step in the process to see if it poses a risk of producing an error on the financial statement. For example, financial controls should stipulate that the larger the amount of the write-off, the higher up the chain of command it has to go to be approved.

Deductions

Financial controls need to be in place for when customers take deductions from their invoices. These deductions can be for things such as poor quality, wrong product shipped, wrong price, shipped to the wrong location, wrong quantity shipped, and billed on the wrong purchase order. Customers will pay only for exactly what they ordered.

Controls need to manage how these disputes are resolved and who is responsible for getting them resolved. Although the balance is on the customer’s account and therefore is ultimately up to Accounts Receivable to make sure it is dealt with, the resolution will often rest outside the Accounts Receivable area. For example, if a customer is refusing to pay because they believe the price is wrong, the invoicing people need to either correct the wrong invoice or confirm to the Accounts Receivable people that the invoice price is correct as billed. Until that confirmation is received from the Billing Department, Accounts Receivable cannot proceed with collection action because of the pending dispute. Strong financial controls and clear processes need to reduce the risk of the amount of Accounts Receivable deductions on the books having a serious impact on the company’s financial statements.

Risk Imported from other Departments or Functions

Because many processes in Accounts Receivable depend on other departments or functions, the risks associated with those processes can affect Accounts Receivable. Therefore, documenting and assessing their risk of the processes in other departments that are pertinent to Accounts Receivable is required to become Sarbanes-Oxley compliant.

Because Accounts Receivable processes involve sales, shipping, customer service, receiving, finance, inventory control, purchasing, and many others, the risks of the processes in other departments have to be taken into account when evaluating the processes in the Accounts Receivable department. This level of integration requires strong financial controls and a clear understanding of the impact other department processes on the Accounts Receivable risk.

Collusion

Financial controls should be set up to catch any collusion among employees, especially in Accounts Receivable. The best control is a strong separation of duties. For example, the person who is responsible for applying the payments to customer accounts should not have the authority to write off small amounts. Someone else should approve these. If these two are working together to defraud the company, a regular review of all small write-offs should be the responsibility of a third person, preferably outside Accounts Receivable, such as in accounting or finance.

Speaker and author of “Sarbanes-Oxley Simplified”, Mike guides companies through the SOX implementation process. For more information about Mike, please visit his website at www.mikemorley.com. or Mike can be reached at (416) 275-1278.