Accounting For Credit and Collections (Controlling Credit Risk) - Part 7
This is the 7th article in a series about Credit and Collections. This material is adapted from The Automated Accounting Systems and Procedures Handbook (John Wiley, New York 1991) Chapter 4.
4.4 POLICIES FOR CONTROLLING CREDIT RISK
Part of any credit manager’s responsibility includes definition and revision of company credit policies. How well these policies are developed and implemented affect the company’s credit exposure and risk. Generally speaking, policies for controlling credit risk fall into several categories:
- Terms.
- Discounts.
- Payment incentives.
- Low risk credit policies.
TERMS
Selling terms determine when an invoice’s payment is due. The terms granted to a particular customer are directly or indirectly controlled by credit policies. Favorable terms can help attract new customers; unfavorable terms tighten credit and can help reduce the credit risk. Unfortunately, tight credit terms may also scare away customers who would prefer better credit terms.
The system retains terms information in the terms table. As Figure 4-12 shows, this table contains information required to calculate both the invoice due date as well as any discount allowed on the invoice. In this example, the Calculation Type identifies any one of the following
- Net terms.
- End of month terms.
- Split terms.
- Step down terms.
Using a table of information enables different types of terms and their respective calculations to be set and easily changed. Most accounts receivable systems can accommodate the different kinds of terms described here.
Figure 4-12 Terms Table Listing.
| | Discount | | Full Amount |
Terms Code | Description | Calculation
Type | % | Days
Due | | Calculation Type | Days
Due |
05 | CASH ON DELIVERY | 0 | | | | 0 | |
10 | 2/5 NET 15 | 1 | 2.0 | 5 | | 1 | 15 |
12 | 2/10 NET 30 | 1 | 2.0 | 10 | | 1 | 30 |
16 | 1/5 NET 15 | 1 | 1.0 | 5 | | 1 | 15 |
18 | 1/10 NET 30 | 1 | 1.0 | 10 | | 1 | 30 |
19 | NET 30 | 0 | | | | 1 | 30 |
20 | 2/10 EOM NET 30 | 2 | 2.0 | 10 | | 1 | 30 |
22 | NET 16 PROX | 0 | | | | 2 | 15 |
24 | NET 5 OF 2ND MONTH | 0 | | | | 3 | 5 |
40 | SPLIT TERMS 1/3 | 0 | | | | 9 | 30 |
| | | | | | | |
Net Terms. Net terms specify that the full amount of the invoice (the “net” amount) is due at a specified time and that no discounts are permitted. Symbolically, people write this as “N30” or “Net 30,” specifying, for example, that full payment is due 30 days from the invoice date.
End-of-Month Terms. End-of-Month (EOM), or proximo, terms specify that payment must be made by a certain number of days after the end of the current month. For example, all shipments made in January under terms Net 10 EOM or Net 10 Prox must be paid by the 10th of February. Beyond that they will be considered late and will be reported as past due in the accounts receivable aging.
EOM terms can also be used with discounting. Terms designated as “2/10 EOM, Net 30 EOM” indicate that the customer may take a discount of 2% any time before the 10th of the following month and that the full payment must be received by the 30th of that following month.
Figure 4-13 shows a few examples of terms extended under some of these approaches. Many variations are possible. For example, some companies that extend EOM terms require payment before the 10th day of the second month following the invoice date.
Split Terms. Split terms allow an invoice to be paid with a series of timed payments. They call for the invoice to be split into equal parts, the payment due on each part according to a schedule. For example, split terms may be: “20% of the invoice amount is due on the 15th of every month for the next five months”. Split terms can be useful for those customers who purchase a particularly large order.
Step Down Terms. Step down terms allow several discounts to be offered. For example, terms of “1% 10, ½% 20, net 30” allow the customer a larger (1%) discount if he pays within 10 days, a smaller (1/2%) discount if he pays within 20 days and no discount if he pays by the due date—30 days later. The use of step down terms and split terms is relatively rare.
DISCOUNTS
Discounts play a large role in customer credit policy. Usually they are considered part of the credit terms.
Trade Discount. A discount offered to a particular class of customers (i.e., all customers in a particular trade) is referred to as a trade discount. It is an allowed deduction off of the entire invoice amount—usually a percentage of the merchandise amount, exclusive of freight or other charges. Someone may offer a 15% trade discount for any nonprofit customers or a 20% discount to wholesalers, for example. This discount is not time sensitive and the customer may take it regardless of when he makes payments. The discount is accounted for (in the accounting system) when posting or applying the customer’s payment to his account during cash receipts processing.
Cash Discount. A cash discount allows a customer a specified percentage off the invoice amount if he pays the invoice within a certain number of days. Cash discounts primarily exist for competitive reasons, industry norms, and customer expectations. Generally cash discounts cannot be justified economically. It is common practice to designate cash discounts using a slash to separate discount percent and the number of days after the invoice date that the discount is allowed. For example, 2/10 means a 2% discount may be taken if paid up to 10 days after the invoice date. Figure 4-12 shows this and other examples.
Customers can abuse cash discounts and take them when they are not allowed. Because of this, during cash receipts processing the system should calculate whether a cash discount is earned or unearned (based on the cash receipt date). Like the trade discount, the cash discount amount is based on merchandise only and excludes freight or other charges.
PAYMENT INCENTIVES
Some businesses apply additional charges to the invoice that penalize late paying customers. For example, in an effort to prevent a customer from paying his accounts receivable balance late, the system can apply a late charge to any invoice that becomes past due. This can be either a flat amount or a computed charge. A computed late charge is based on (1) the amount past due, (2) a daily factor (interest rate), and (3) the number of days that payment is late.
A finance charge is slightly different. Unlike the late charge, the finance charge is computed on any balance due regardless of whether it is past due. The system may apply a finance charge to the account based on the outstanding balance and the prevailing interest rate for this type of charge.
Late charges and finance charges are common in balance forward systems where the sheer number of low dollar accounts makes negotiating or calling the customer a costly, impractical alternative. In contrast to discounts and anticipation deductions that are more controlled by the customer (and subject to abuse), these payment incentives are more strictly controlled by the accounts receivable system.
LOW-RISK CREDIT POLICIES
Credit managers often employ a few other credit policies to reduce credit risk. The payment approaches discussed here are low-risk alternatives to allowing a customer to have full credit terms.
Advanced Payment. Risky, marginal accounts may be restricted to special terms requiring up front payment by the customer. The common form of this involves the shipper collecting cash or a check from the customer upon delivery of the goods. This is called cash on delivery, or COD. The disadvantage of this approach is that the shipper usually charges a small fee—usually a percentage of the amount—for collecting the cash.
Stricter approaches call for cash to be received before the shipment. With cash before delivery (CBD) the cash must be received before the goods are shipped; with cash in advance (CIA) the order cannot be processed until payment is tendered.
Partial COD. Another approach for marginal accounts requires that half of the invoice amount be paid via COD and half be paid on trade credit (terms). Businesses may use this for new customers who wish to place a large order. Some accounts receivable systems implement partial COD terms via a terms table entry that allows split terms with half of the amount due on the shipment date and half of it due a specified number of days later.
Letters of Credit. Collection of accounts receivable overseas can be so costly and difficult that many companies would not sell to overseas customers if letters of credit were not available. Also called a documentary letter of credit, this is a common vehicle for arranging the payment of goods delivered overseas; it involves substituting a bank’s credit for the foreign customer’s. In this bank an account is set up by the buyer (customer) and backed by his deposits. The bank, not the customer, guarantees the line of credit and this agreement is subject to a set of terms and conditions detailing the delivery and acceptance of the goods.
Some special accommodations may be required for the invoicing system to arrange payment via letter of credit. The system should indicate on the invoice: the letter of credit number, the name of the issuing bank (that is, the buyer’s bank), and any other appropriate information.
A standby letter of credit is an on-going guaranty from a buyer’s bank that the bank will pay for goods or services in the event that the buyer refuses or is not able. This instrument of credit is used to reduce the risk of extending credit to a questionable customer who might otherwise not be sold to on credit. The beauty of a standby letter of credit is that it does not require all of the acceptance procedures and paperwork needed for a documentary letter of credit. In the event of nonpayment by the buyer, the seller simply furnishes the bank with
- Proof of delivery.
- A copy of the packing slip.
- A copy of the invoice.
The bank will then remit payment and charge the buyer’s account. Standby letters of credit are quite popular with domestic customers, as well as overseas customers.
| About this article and the author: |
Doug Potter is the owner of The Newport Consulting Group a professional management consulting organization that provides clients with information systems planning, selection, and implementation services. He can be reached at dpotter@newportconsulting.com or through his Web site, http://www.newportconsulting.com.
Note: The contents of this article were excerpted from Mr. Potters book "Automated Accounting Systems and Procedures Handbook" Copyright 1991 by Douglas A. Potter, published by John Wiley & Sons, Inc. New York
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