Help CPA Clients Get More Money From Lost Receivables

A couple of weeks ago I was out at a client’s office for an engagement talking to the CFO about their 6/30/2013 end-of-year financial statements. My client is a lighting equipment and parts manufacturer, and has been in business for many years. As we were reviewing the numbers, the conversation turned to the very low amount of bad debt expense. On sales of about $20 million, write-offs against total sales were less than $100K (a .5% write-off rate) and I mentioned to the CFO that this write-off rate is quite enviable. He looked at me with a sense of immense pride and softly responded, “Our customers are very credit worthy.”

Like any good credit risk management consultant, we have to go far beyond the numbers and really look at what’s not on the financial statements to understand their true meaning. I asked the CFO for the latest accounts receivable aging report and within a couple of minutes I understood why they had only a .5% write-off rate.

In analyzing the report, I concluded that about 5% of total sales was between 180 – 360 days past due and an additional 2% were over 1 year past due. Given that the client’s general payment terms are net 30 days, the accounts past 180 days were urgently worrying me. In other words, although my client officially wrote off only .5% of their sales due to being uncollectible, some portion of the 7% of their total sales that were over 180 days past due may have to be written off as well. Since there were about two dozen customers that still had not paid and the median range of the unpaid receivable per customer was about $180,000, there seemed to be a real problem here.

Generally speaking, when an account hits the 180 day past due mark, the collectability of that account drops down to 50%. When an account is still not paid at the 1 year past due point, it drops down to a 20% collectability rate, and by 2 years we’re looking at a 10% at best collectability rate (note: the Commercial Law League of America, the oldest commercial collection association in the US, has published these collection statistics on several occasions).

So in view of my client’s $1.4 million in receivables past the 180 day point, that .5% write off rate on the financial statements now appeared to be misleading.

From the CFO, I meandered over to the credit  and collection manager, and one by one we went through each account over 180 days to ascertain what the collection status was. As we discussed each account, many of them were in a pending status which involved one of the following action items:

  • There was a significant quality problem that some of the accounts complained about and until it was rectified, payment was being held.
  • The Director of Sales had a “special relationship” with a few of the larger customers and since there were some very complex problems with the product that needed to be resolved, for the past year he has been the only one allowed to talk to these accounts.
  • Merchandise returns for a few customers still had not been properly credited and until they were recorded and issued, the customers were not paying.
  • Some accounts had been great customers for a long time and over the past year or so had fallen on hard times. New orders were being released on a cash in advance basis but payment for existing sales was still not being received.

A few accounts were actually in a collection status:

  • The credit and collection manager was collecting two large accounts of about $50,000, each on a monthly payment installment basis of $1,000 per month.
  • A couple of accounts where in third-party collections but the outlook for their being collected was very low since the accounts were out of business.
  • A couple more of accounts were in the process of being sued.
  • A couple of final accounts actually had judgments against them but still appeared uncollectible.

So the real problem here is threefold:

The first problem is that the accounts outstanding for reasons of dispute, recording of credits and special handling are not being resolved on a timely basis. When it comes to disputes and the recording of credits, there really is no excuse for getting these items processed. Once the disputes (like quality) are resolved and credits are recorded, at least the client would now be in a position to start collecting them.

The second problem is that the company’s credit risk management policy needs to be amended to clearly state the process to be taken on past due accounts that are not being paid due to disputes or other issues that are impeding prompt payment. For example, even though the director of Sales had a “special relationship” with a few of the larger customers, in my view, there needs to be a time line in which these kinds of accounts have to reach a conclusion. It will certainly hurt to write these accounts off, but that’s a business decision that may have to be made. Just letting them sit out there on the aging report forever with the hope that the director can resolve them is just poor internal handling of these kinds of situations.

The third problem is that the write-off rate of .5% was not representative of the actual rate – and in view of the amount that should probably have been written off, this rate will need to be restated.

Over the next week of my engagement, we evaluated several accounts that were determined to no longer be collectible and this in turn resulted in the write-off number and rate to be restated to $600,000 and 3% respectively. The CFO was not too pleased by this restatement since it could effect their borrowing relationship. However, better he should be dealing with the reality of the situation and improve his internal controls and processes than continue to believe in a .5% write-off rate fantasy.