What is Aging of Accounts Receivable?
Definition: Aging of accounts receivable is the process of sorting receivables by their due dates in an effort to estimate the amount of uncollectible accounts. In other words, the aging process classifies the existing past due receivables into categories based on their past due date in an attempt to estimate an allowance to each account. The older receivables are obviously less likely to be collected than the newer ones and consequently get higher allowance estimates.
Accounts receivable aging (tabulated via an aged receivables report) 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 of a company’s customers. If the accounts receivable aging shows a company’s receivables are being collected much slower 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.
What Does Aging Accounts Receivable Mean?
An accounts receivable aging is a report that lists unpaid customer invoices and unused credit memos by date ranges. The aging report is the primary tool used by collections personnel to determine which invoices are overdue for payment. Given its use as a collection tool, the report may be configured to also contain contact information for each customer. The report is also used by management, to determine the effectiveness of the credit and collection functions. A typical aging report lists invoices in 30-day “buckets,” where the columns contain the following information:
- The left-most column contains all invoices that are 30 days old or less
- The next column contains invoices that are 31-60 days old
- The next column contains invoices that are 61-90 days old
- The final column contains all older invoices
The report is sorted by customer name, with all invoices for each customer itemized directly below the customer name, usually sorted by either invoice number or invoice date. A sample report follows, though without the individual invoice detail that is usually found in such a report:
If the report is generated by an accounting software system (which is usually the case), then you can usually reconfigure the report for different date ranges. For example, if payment terms are net 15 days, then the date range in the left-most column should only be for the first 15 days. This drops 16-day old invoices into the second column, which highlights that they are now overdue for payment.
The report primarily contains invoices, but it may also contain credit memos that have not been used by customers, or which have not yet been matched against an unpaid invoice.
The aging report is also used as a tool for estimating potential bad debts, which are then used to revise the allowance for doubtful accounts. The usual method for doing so is to derive the historical percentage of invoice dollar amounts in each date range that usually become a bad debt, and apply these percentages to the column totals in the most recent aging report.
For example, a company historically experiences 1% bad debts on items in its 30 day time bucket, 5% bad debts in its 31-60 day time bucket, and 15% bad debts in its 61+ day time bucket. Its most recent accounts receivable aging report contains $500,000 in the 30 day time bucket, $200,000 in the 31-60 day time bucket, and $50,000 in the 61+ day time bucket. Based on this information, the company should have an allowance for doubtful accounts of $22,500, which is calculated as:
($500,000 x 1%) + ($200,000 x 5%) + ($50,000 x 15%) = $22,500
An additional use of the aging report is by the credit department, which can view the current payment status of any outstanding invoices to see if customer credit limits should be changed. This is not an ideal use of the report, since the credit department should also review invoices that have already been paid in the recent past. Nonetheless, the report does give a good indication of the near-term financial situation of customers.
Finally, the company’s auditors may use the report to select invoices for which they want to issue confirmations as part of their year-end audit activities.
Benefits of Accounts Receivable Aging
The findings from accounts receivable aging reports may be improved in various ways. First, accounts receivable are derivations of the extension of credit. If a company experiences difficulty collecting accounts, as evidenced by the accounts receivable aging report, specific customers may be extended business on a cash-only basis. Therefore, the aging report is helpful in laying out credit and selling practices.
Companies will use the information on an accounts receivable aging report to create collection letters to send to customers with overdue balances. Accounts receivable aging reports mailed to customers along with the month-end statement or collection letter provides a detailed account of outstanding items. Therefore, an accounts receivable aging report may be utilized by internal as well as external individuals.
How Management Uses Accounts Receivable Aging
Below are a few ways that company management can use the accounts receivable aging report:
1. Collection practices
One of the ways that management can use accounts receivable aging is to determine the effectiveness of the company’s collections function. If the aging report shows a lot of older receivables, it means that the company’s collection practices are weak.
Some customers tend to not pay their invoices when they are due, and they may wait until the second and third invoice reminders to settle their outstanding balance. If some customers are taking too long to settle pending invoices, the company should review the collection practices so that it follows up on outstanding debts immediately when they fall due.
2. Credit risk
The accounts receivable aging report can also indicate which customers are becoming a credit risk to the company. Older accounts receivable expose the company to insolvency due to the risk that the debtors may be unable to pay the invoice.
If the report shows that some customers are slower payers than others, then the company may decide to review its billing policy or stop doing business with customers who are chronically late payers. Management may also compare its credit risk against industry standards, in order to determine if it is taking too much credit risk or if the risk is within the normal allowed limits in the specific industry.
3. Allowance for bad debts
Management may also use the aging report to estimate potential bad debts during the reporting period. They evaluate the percentage of an invoice dollar amount that becomes bad debts per period and then applies the percentage to the current period’s aging reports.
For example, assume that Company XYZ allows for a 1% bad debts allowance for the 0 to 30 days period and a 3% bad debts allowance in the 31 to 60 days period. In the current period, the company reports $100,000 debts in the 0 to 30 days period and $50,000 debts in the 31 to 60 days period. This means that the allowance for bad debts is $2,500 based on the following calculation:
Allowance for Bad Debts = [($100,000 x1%) + ($50,000 x 3%)] = $1,000 + $1,500 = $2,500
Why Is Accounts Receivable Aging Report Important?
Here are some benefits that the accounts receivable aging reports provide:
- Contact clients at regular intervals so they know you’re on top of your billing and collection process
- Evaluate payment terms with suppliers and make necessary changes
- Sever ties with clients who regularly struggle to pay their invoices on time, which in turn can lead to cash flow problems for the business
- Stop providing goods or services before late payment becomes an issue and you have to write off bad debts
- If you decide to factor your outstanding invoices as a financing tool, one of the documents your factoring company will require is an accounts receivable aging report. It is used to help determine the factoring rate.
Without an accounts receivable aging report, it can be difficult to maintain a healthy cash flow and identify potentially bad credit risks to your business. While generating the accounts receivable aging report, make sure to include the client information, status of collection, total amount outstanding and the financial history of each client.
The task is easier when you use accounting software that allows you to customize client settings such as sending automatic payment reminders for specific clients, specifying the intervals to send the reminders, and the ability to include a personalized message.
Possible issues in Accounts Receivable Aging Reports
Although an accounts receivable aging report helps the management team better know the financial state of the company, it may provide information that is misleading, depending on the time when the aging report is generated. For example, most companies bill their customers toward the end of the month, and the aging report is generated days later. This means that the report will show the previous month’s invoices as past the due date, when, in fact, many of them were paid just shortly after the aging report was generated.
Also, generating the report before the month ends will show fewer receivables whereas, in reality, there are more receivables pending payment for the company. Management should match their credit terms to the periods of the aging reports to get an accurate presentation of the accounts receivable.
- Accounts receivable aging is the process of distinguishing open accounts receivables based on the length of time an invoice has been outstanding.
- Accounts receivable aging is useful in determining the allowance for doubtful accounts.
- The aged receivables report tabulates those invoices owed by length, often in 30 day segments, for quick reference.