What is the Accounts Receivable Process?
The accounts receivable process is when a customer purchases a service and/or good and the outstanding payment has been received by the merchant, where the accounts receivable serves as an “IOU” until payment.
The 10-Step Accounts Receivable Process
- Develop a Credit Application Process
- Create a Collection Plan
- Compliance with Consumer Credit Laws
- Send Out Invoices
- Choose an Accounts Receivable Management System
- Track the Collection Process
- Log All Charges and Expenses in Real-time
- Incentivize Early Payment Discounts
- Build and Maintain Customer Relationships
- Create a Plan for Escalation
How to Process Accounts Receivable
An “account receivable” is created when a business allows a customer to take immediate possession of a product/service, in return for a promise to pay (IOU). It’s the same idea when a business accepts credit cards, except you assume the risk instead of the credit card company.
The accounts receivable process is designed to provide healthy cash flow to support growth and profitability. Thus, you should have a plan in place for how you want to process this part of business accounting.
Prior to extending credit to anyone, procedures should be established for how that is done, who receives credit, and what happens next. The following is a step-by-step guide to the most effective AR process, including credit management, invoicing, and documentation.
#1) Develop a Credit Application Process
The first step is to determine how you will extend credit to customers and who will be eligible. There must be a credit application process in place to provide a company with the information it needs to make an educated decision.
Some organizations choose to only extend credit to other companies and not individual customers. In order to evaluate creditworthiness, a business needs to run a credit check on all applicants. This should include information like:
• Contact data
• Employment information
• Social security number
If it’s a business, the contact information of the accounts payable department must be given. Additionally, if the orders are large or high in volume, references from other companies who have extended them credit should be required.
The credit application form must also have a place where the customer checks and signs for acknowledgment of all terms and conditions. This includes everything stated in the business agreement.
#2) Create a Collection Plan
In this next step, it’s time to look at the details and settle on a business agreement. Ask clients what is convenient for them in terms of cash flow.
Some customers prefer to be billed monthly, while others must be billed weekly. Both parties must agree on the time frame of receiving payment. This starts with drawing up a business agreement and establishing the terms and conditions of credit sales.
This document will explain a company’s requirements and a customer’s obligations. It will specify when payments are due, payment options, how much interest (if any) is charged for late payments, rules on refunded checks, debt collection fees, and more.
Consider these key factors when creating a new business agreement:
• AR cash flow. If a business needs to get money in faster, then the payment terms must be shorter.
• A customer’s payment history. If a customer has always been on time, you can be lenient when an extension is needed. If they have been late, a more detailed payment plan can be considered.
• Industry standards. What are the billing practices in your field? A business can decide to match those average payment terms (usually 30 days) or give a little wiggle room to create a competitive edge.
Both parties should have a firm agreement on a date and send electronic invoices for better recordkeeping. This will help to streamline the accounts receivable process flow.
#3) Compliance with Consumer Credit Laws
There are specific laws set forth to protect consumers and their credit. The Federal Trade Commission (FTC) enforces laws that protect consumers and makes sure customers receive full disclosure about a company’s credit practices.
To ensure a business is complying with consumer credit laws, they should consider the following rules:
• Clearly communicate the interest rate
• Reply to all billing mistakes in a specific amount of time
• Follow all regulations for debt collection practices
• Visit the FTC to stay consistently up-to-date with debt collection laws
If you need more information on FTC regulations, look into the Fair Debt Collections Practices Act and consumer equal credit opportunity rights.
#4) Send Out Invoices
The next step is to choose how you will invoice customers. The larger the business, the more important it is to digitize processes. A high volume of clients with a variety of needs and payment methods can lead to confusion and mistakes.
No matter paper or digital, an invoice must contain specific information that identifies the customer and the goods or services provided. It should include the following data:
• A unique invoice number
• The date clearly displayed
• The business name and address of both parties
• A clear description of service/product provided
• The amount that is due
• Payment due date
Invoice processing is a critical step in the accounts receivable and payable process.
#5) Choose an Accounts Receivable Management System
After the invoices go out, it’s time to think about the type of accounts receivable system you want. While some small businesses are comfortable with an offline, manual setup (think Excel), the truth is it’s not an ideal method for modern accounting.
The majority of clients most likely operate on digital systems and thus, to stay in line with competition and customer needs, digitizing the process is a smart move. That’s where accounts receivable management software comes in.
An automated AR solution keeps track of invoices and payment due dates. Your trial balance and all necessary collections data are housed in one, convenient dashboard. All customer and sales data can be loaded into the system, where digital invoices are instantly generated. This makes paper files of unpaid invoices a thing of the past.
#6) Track the Collection Process
Once a system is in place, a plan for collections must be drafted. Inevitably, you will have a customer that simply doesn’t pay. In this instance, there must be a game plan to collect what is owed. This starts with documenting the entire AR process to audit and optimize the program.
In order to track what invoices are owed and when, a business should perform an invoice age analysis. This report separates invoices by how many days late they are. There is grouped data for current invoices, overdue by 0-30 days, 31-60 days, 61-90 days, and more than 90 days late.
The invoice age analysis enables business owners to follow a collections policy that specifies when certain actions should be taken, like sending something to a collections agency. This report can help estimate bad debt accrual and identify invoices that need follow-up action.
#7) Log All Charges and Expenses in Real-time
All charges must be logged in real-time. AR software should have the ability to scan orders, receipts, and requests right as they arrive. Any corresponding document needed for invoice processing should be uploaded in the system and paired with the appropriate documents.
#8) Incentivize Early Payment Discounts
One of the toughest jobs in the accounts receivable process is getting payments in on time. Securing timely and consistent cash is the name of the game. Some customers simply need a little push and that incentive can come in the form of early payment discounts.
This can be printed right on the invoice or included in the business agreement. Not every customer will have a strong enough cash flow to make it work, but companies that do accept these discounts typically pay early on a consistent basis.
#9) Build and Maintain Customer Relationships
One of the best-kept secrets about a successful accounts receivable process is maintaining strong customer relationships. The more your customers appreciate the business, the more likely you will be paid on time.
This starts with consistent contact on a friendly basis. When an AR staff is acquainted with a company’s AP team, the easier the collections process becomes. Your business processes should always focus on the client and maintaining an ongoing level of satisfaction.
#10) Create a Plan for Escalation
Although a business may not like it, there comes a time when a customer simply refuses to pay. It could be cash flow problems on their end or a dispute over the service or product provided. Unforeseen circumstances mean there must always be a plan for escalation in the event of nonpayment.
Setting up payment expectations in the business agreement is a proactive approach to avoiding bad debt. A company should also work with a collection agency in case they need to write off unpaid invoices.
A plan of escalation should include AR staff reaching out several times via any form of communication they have. After there is no response, a formal letter of demand can be sent, before the debt is finally turned over to a collection agency.
At this point, a company can decide whether or not they want to blacklist the customer from doing further business. Planning ahead enables staff to be more efficient during the collection process, making it possible for the rest of the business to focus on growth.
Marks of a Successful Accounts Receivable Process
What defines a successful accounts receivable process? Indicators include a low amount of debt and a high rate of early payments. The AR staff supports the balance sheet by minimizing the number of late payments through systemic monitoring and consistent follow-up.
Optimizing the process starts with credit applications from new customers. Work is done to determine creditworthiness and set credit limits that encourage purchasing without credit risk. From there, the accounting system provides the data needed to send invoices, where automation saves a huge amount of time.
Finally, a successful AR process will send follow-ups to encourage prompt payment of outstanding invoices. They will run ongoing invoice aging reports to determine late payments and take a proactive approach to the collections process.
Traditional vs. Modern Accounts Receivable Automation
A traditional approach to the accounts receivable process involves a lot of manual entry, extra time, and labor costs. It begins when a customer makes a purchase and ends once the outstanding payment is collected. Everything is logged manually on the balance sheet, opening the possibility up to human error at every corner.
In traditional AR, the collections method is less of a straight line and more circular, as customers pay invoices and continue to purchase products/services.
The manual AR process usually involves:
- Generating invoices through Excel or MS Word
- Printing invoices, then mailing or emailing them out
- Manual payment verification and follow-up through calls/emails
- Manual journal entry and bank reconciliation
It’s a time-consuming process with a huge potential for error. It oftentimes leads to an inefficient AR workflow with a ton of wasted time.
In a modern accounts receivable approach, everything is digitized. Accounting software removes the possibility of human error by automatically generating invoices and keeping track of who has paid what in the system.
With AR automation, everything is instantly updated and data gathered in reports so staff can spend more time identifying patterns and streamlining workflow, and less time chasing paper.
Accounts Receivable Best Practices
What can a business do to ensure the AR cycle is properly managed and cash flow is maximized? Here are a few pointers:
Provide an Estimate/Quote
Prior to drafting and signing a business agreement, a company should provide the customer with an estimate. The quote includes the specific products/services sold, sales price, credit terms, etc.
A quote enables customers to have an understanding of costs in advance and to avoid any surprises when the invoice shows up. This leads to a quicker invoice approval process and faster payment in the door.
Create a Follow-up Policy
Create a follow-up policy that universally applies to all clients. Any time a payment is missed, a team member should send out a notification. An automated AR system will do this instantly when an invoice falls into a certain bracket of “past due”. It will automatically send digital reminders for delinquent accounts.
Establish Key Performance Indicators
Key performance indicators (KPIs) measure the health of the accounts receivable process. One of the most important metrics to watch is called DSO (days sales outstanding). This tracks the average amount of time it takes to get paid after sending an invoice. Other metrics to consider monitoring include:
- Invoice accuracy
- Average days to invoices
- Credit overruns
- Customer complaints
Benchmarks should be set for these metrics with baseline data. Then, goals can be set for each metric to optimize AR collection management.
Regular Aging Review
It’s important to proactively manage the AR collection process immediately upon invoicing. The aging report must be viewed on a frequent basis, and the appropriate actions taken. Accountability should be given to an AR staff member and a plan established for following up with delinquent accounts.
Different Payment Methods
Providing customers with several different ways to pay, enables faster payment. In addition to paper checks, accepting credit cards and ACH payments can shorten the entire AR cycle and increase cash flow. In today’s world, payments can even be made on a mobile device in a matter of minutes.
Input Payments Immediately
If it’s not done through automated software, all payments should be input immediately. The funds must be applied in the accounting records to a specific invoice and closed out. This ensures all management has the most up-to-date aging report for review.
Invoice Dispute Process
Invoice disputes can sour the client relationship if not handled properly. A company gets ahead of these issues by creating an established policy for disputes. This includes answering questions like:
- What type of supporting documents are needed?
- Who handles client contact?
- What is the procedure for failed payment?
The faster invoice issues are resolved, the more likely a positive business relationship will continue.
Forecasting Ongoing Revenue
Companies with customers that are charged on a monthly, quarterly, or annual basis should have accounting procedures to schedule future invoicing. Forecasting allows a company to compare invoices for recurring charges against expectations to determine if there was any failure in the system. Automating the process means invoices are sent on the same day, every month, to avoid any unexpected delays.
At this point, it’s wise to automate the entire accounts receivable process. Start looking for a solution within your budget that meets specific business needs. Leverage automated AR collection tools for help with tasks like:
- Analyze financial metrics and KPIs
- Eliminate time spent on manual tasks
- Generate automatic reminders and reports to stay on track
Accounts receivable is vital because when you run out of cash, a business fails. That’s why efficient cash flow management is imperative for success. Typically, the source of all cash flow problems in a business is poor handling of AR.
The more cash tied up in receivables (due to slow-paying customers and delinquent accounts), the less cash is available for running the business. Mismanaged revenue cycle accounting leads to cash flow disruption, compounded by internal labor costs and external vendor fees.
The best plan is to stay on top of the accounts receivable cycle by employing an automated software solution to optimize the process and digitize workflows. This will offset costs, decrease the DSO, and lead to a higher rate of satisfaction for all parties involved.