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INTERDISCIPLINARY JOURNAL OF CONTEMPORARY RESEARCH IN BUSINESS

DETERMINANTS OF ACCOUNTS RECEIVABLE

AND ACCOUNTS PAYABLE: A CASE OF

PAKISTAN TEXTILE SECTOR

MUBASHIR ALI KHAN

(Corresponding Author)

MS Scholar

Sukkur Institute of Business Administration

Airport Road Sukkur, Sindh, Pakistan

GHULAM ABBAS TRAGAR

MS Scholar



NIAZ AHMED BHUTTO

Associate Professor





Abstract

The objective of this study is to analyze the determinants of Pakistani listed companies’ accounts receivable and accounts payable focusing the textile sector. It is evident from the findings that accounts receivable are strongly affected by the firm’s incentive to use trade credit as a means of price discrimination and level of internal financing. Additionally, the size of the firm also affects the level of accounts receivable a firm maintains. Whereas, most significant determinants of accounts payable are size of the firm, level of purchases and market interest rate.

Keywords : Trade Credit, Price Discrimination, Accounts Payable, Textile Sector

• INTRODUCTION

In corporate finance trade credit has been supposed to be a nonissue for a long time, at least in the context of perfect markets (Sartoris and Hill, 1988). Nevertheless, it is observed that a significant quantity of cash is invested in accounts receivable and an enormous amount of accounts payable, as a source of financing in nearly all non-financial firms (Deloof and Jegers, 1999). Significance of trade credit differs among the countries and it is expected to be higher in the countries which produce more manufacturing products, although there is


Service Management System substantial difference across them (Marotta, 1998). Rajan and Zingales (1995) compared non-financial companies in the G7 countries and found that relative part of accounts receivable differs between 29% Italy and

13% Canada, on the other hand, the respective limits for accounts payable were

17% France and 11.5%

Germany. Mian and Smith (1992) reported that in 1986 US manufacturing firms had

21 percent of accounts receivable of their total assets and about 40% of account payable of their total liabilities. Deloof and Jegers,

(1999) reported that in 1995 Belgian nonfinancial firms’ accounts receivable were

16% of total assets, and accounts payable 12% of total liabilities. Several studies have been conducted to simply analyze the existence of trade credit (see a.o. Schwartz, 1974; Feriss,

1981; Frank and Maksimovic, 1998; Long, Malitz and Ravid, 1993; Brennan,

Maksimovic and Zechner, 1988; Brick and Fung, 1984; and Emery, 1984 and

1987), but very few studies have discussed the reason behind the trade credit is offered or which corporations use it or delivers it most (Petersen and Rajan,

1997). Storey (1994) analyzed earlier work on the financing patterns of UK small companies and found that for small firms trade credit is more valuable than for large firms. Whereas Walker (1991) investigated the US small firms and found that US small firms are also relying on trade and bank credit and these two financing sources are being used as substitutes.



Furthermore, it is always argued that borrowing at rational rates is an issue for corporate decision makers. Berger and Udell (1998) suggested that when borrowing outside the firm, small firms face particular restrictions. Borrowing a small amount of capital from external capital markets becomes their obstacle, which is usually called as Macmillan gap, and for this reason they are being offered higher interest rates (Storey, 1994). While market imperfections, just as, agency costs and asymmetric information, are the reasons of these issues as proposed by several economic theorists. Even risky debt has a preference when information asymmetries are not favorable. Mayers (1984) pointed out this situation as ‘pecking order’ theory of financing in which a firm first raises capital internally by reinvesting its net income and selling off its short-term marketable securities. When that supply of funds is exhausted, the firm will issue debt and perhaps preferred stock. Only as a last resort will the firm issue common stock. Whereas, it has also been reported by several studies that close bank-borrower association improves credit accessibility (Niskanen and

Niskanen, 2006). Other studies propose that the availability of credit is affected positively by bank-borrower relationship (Petersen and Rajan, 1994).

•

LITERATURE REVIEW

Danielson and Scott (2004) investigated the effect of bank loan availability on the trade credit and credit card demand of small firms and found that firms increase their demand for trade credit and credit card debt when facing credit constraints are imposed by banks. Deloof and Jegers (1999) investigated the role of trade credit as source of financing for Belgian firms focusing accounts payable and found that trade credit plays a significant role in the corporate financing policy. They found that the amount of trade credit a customer takes is determined by the need for funds and by the internally available funds. Finally they found that trade credit can act as a vital substitute for short term as well as long term financial debt. Atanasova (2007) tested for the existence of credit constraints and their effect on the corporate financing policies and found that credit constrained firms substitute trade credit to institutional finance especially


Service Management System during tight money periods. Huyghebaert (2006) tested hypothesis that why firms use trade credit on business start-ups and find that more trade credit is used when firms face financial constraints and suppliers have a financing advantage over banks in financing high risk firms. Niskanen and Niskanen

(2006) analyzed credit policies of Finnish small firms functioning in bank dominated environment. Creditworthiness and access to capital markets were found as important determinants of trade credit extended by the sellers. Firm’s age, size and level of internal financing were found to be negatively correlated to the trade credit usage, whereas level of current assets to total assets and loan availability were found negatively correlated with the trade credit usage. In addition to it, the level of purchases was found positively correlated with level of accounts payable. Niskanen and Niskanen (2000b) analyzed the accounts receivable and accounts payable of Finnish listed firms and found that accounts receivable are most likely to be influenced by the firms’ incentive to use trade credit as a means of price discrimination. Through increased demand for the trade credit level of accounts receivable increases with the increase in the interest rate level. Additionally, they found that the level of accounts payable is affected by the firm size, supply of trade credit, interest rate level, the ratio of current assets to the total assets, and insufficient internal financing. Blasio

(2005) tested the Meltzer (1960) trade credit

– bank credit substitution hypothesis on Italian manufacturing firms’ inventory behavior and found that during money tightening Italian manufacturing firms are more constrained than normal macroeconomic conditions.

• THEORIES AND EMPIRICAL EVIDENCES ON TRADE CREDIT

Various theoretical studies have tried to investigate the reason of providing intermediary services by suppliers to their customers and to find out the rationale to use trade credit as a substitute of less costly bank debt.

3.1. Transaction Costs



Transaction Costs have been declared to be one rationale to sustain credit sales. Transaction costs theory describes that paying at once for several shipments collectively saves transaction costs and permits flexibility in payments (Ferris, 1981).Furthermore, money can be saved by keeping smaller cash balances.

3.2. Financial Models

Financial models are based on capital market imperfections concerning information asymmetries. These imperfections lead to the phenomena in which firms, with lower cost of financing due to their better access to capital markets, tender trade credit to other financially constrained firms (Schwartz, 1974).

Furthermore, trade credit facilitates firms to support the growth of their clients. It is also believed that trade credit can serve to alleviate credit rationing problems as trade credit plays as a signal on the buyers’ good quality to the financially intermediary (Frank and Maksimovic, 1998; Biais and Gollier, 1997).

Financial theory proposes that the seller has a lead over financial institutions in information gaining and controlling the consumer. In European countries, all these gains speak about the nearer and greater relationship between buyer and seller than between the financial institutions and buyers. That is supplier have a threatening tool to stop future supplies when consumer does not pay in time.

On the other hand a financial institution may not have a device like this to have power over consumers, while warning to depart future lending may not have instant consequence on the consumers’ attitude (Petersen and rajan, 1997).

3.3. Price Discrimination

Price discrimination is a possibility of charging dissimilar prices for dissimilar consumers. This can happen in a situation when credit conditions include discounts on paying before time. These conditions are mostly presented by leading firms in the industry (Brennan et al., 1988; Mian and Smith, 1992).



These firms have an advantage to collect extra sales to existing clients without decreasing price. As a result these firms extend high priced trade credit which is not acceptable for creditworthy customers. While for low rating companies this credit may be acceptable as it might be less costly than borrowing from financial intermediary (Brennan et al., 1988; Petersen and Rajan, 1997).

Additionally, trade credit offers a facility to gauge the quality of products earlier than paying for it s o this becomes an inherent guarantee for the seller’s manufactured goods (Lee and Stowe, 1993). For small and less reputable sellers this facility of trade credit may have a great importance (Frank and

Maksimovic, 1998).

3.4. Macroeconomic Conditions

Macroeconomic conditions have also an effect on trade credit usage and conditions which cannot be ignored and has been highlighted by many researches. Kashyap et al., (1993) investigated the effect of macroeconomic factors on trade credit and found that under restrictive monetary policy and controlled money supply smaller firms are ready to extend trade credit on the given conditions as increasing borrowing rates create trade credit a supplementary viable type of short term funding. Petersen and Rajan (1997) highlighted the same issue and found that firms extend trade credit when loan from financial intermediaries is not present. They further added that, in this scenario, the role of financial intermediary will be performed by larger suppliers as firms having no access to institutionalized financial markets will borrow from these larger firms.

• DATA DESCRIPTION AND DEPENDANT VARIABLES

The data sample of this study comprises of financial accounting information of the firms listed at Karachi Stock Exchange during 2004 to 2009.This accounting data is extracted from the Balance Sheet Analysis published by the State Bank


Service Management System of Pakistan. After excluding missing firm year data from analysis 891 observations were analyzed from 151 firms.

• RESULTS

5.1. DETERMINANTS OF ACCOUNTS RECEIVABLE

Carrying receivables has both direct and indirect costs but it also has an important benefit that is increased sales. Receivable management begins with the credit policy, but a monitoring system is also important. Corrective action is often needed, and the only way to know whether the situation is getting out of hand is with a good receivables control system.

• Demand for Trade Credit

A firms’ decision on how much to lend to its customers is determined from the level of firms’ accounts receivables. Still the quantity of trade credit, a firm offers, is influenced by a demand component (Petersen and Rajan, 1997). This demand on the whole is not possible to compute directly as approaches of nearly all firms’ consumers to trade credit varies. This is due to the reason that, just for example, a retail company can contain thousands of credit consumers which can be either persons or other firms. Whereas, the accounts payable of a particular company, can be similar in greater part as they are payable to the other companies which are comparatively little in number in any particular industry. As the demand curve for trade credit is not identified, interpretation of estimated coefficients can help in understanding this problem.

Petersen and Rajan (1997) found that large firms maintain higher accounts receivables. One reason for this result can be, the greater access of larger firms to capital markets which makes them less capital reserved. Second reason can


Service Management System be the demand component from capital rationed firms that causes the accounts receivable of larger firms higher than average.

• Creditworthiness and Access to Capital Markets

Firm size and age are used to compute the firm’s creditworthiness and access to capital markets. The natural log of firm age (Ln(1+ firm age)) is used as proxy for creditworthiness and natural log of total assets (Ln(book value of assets)) is taken to proxy the suppliers’ access to external capital. The results in the Table 1 show that size is significant variable with (p = 0.000102129).

These results are consistent with earlier studies like Petersen and

Rajan’s(1997).

• Internal Financing

The study uses operating cash flow (earnings before depreciation and interest minus taxes) divided y assets to gauge the firm’s capability to produce cash from internal sources to fund the trade credit which it extends to its customers.

The results indiate that internal financing effects positively to the level of accounts receivables. The variable is positive and significant at (p=

0.00000000) which indicates that the larger the positive cash flow the supplier has, the higher the trade credit he is ready to offer to its customers. The results are consistent with findings of Niskanen and Niskanen (2000) and are contradictory to the findings of Petersen and Rajan (1997).

Model I: AR = β0 + β1CF + β2CM + β3GR + β4KIB + β5SIZE

Table 1: Dependant Variable:

Accounts Receivable/Assets

β

0

β

1

β

2

β

3

β

4

β

5



-

Coefficient 42.702

1.457* -698.612* 0.0533

0.634

15.291*

S.E

26.690

0.110

123.976

0.179

1.197

3.892

P-Value (0.110) (0.000) (0.000) (0.766) (0.596) (0.000)

F-Value 45.596* R-Square 0.384

Adjusted-

R 2

DW

0.376

1.037

(0.000)

*Significant at

α = 0. 01 **

Significant at

α = 0. 05

• Price Discrimination

Price discrimination is an act of billing the same product to different clients with different prices, even when the costs of supplying them are same. This practice is mostly observed by monopolists as they exploit their leading power for discrimination. This study uses ratio of contribution margin (sales minus variable costs) to assets to proxy for monopoly power to carry out price discrimination. In our sample of all textile firms existing on Karachi Stock

Exchange, it is found that a significant but a negative relationship exist between price discrimination and accounts receivable management policies which is validated by a p value of (p= 0.00000004). These results are contradictory to the findings of Niskanen & Niskanen (2000).

•

Cost Of Alternative Capital



The study uses annual average three month KIBOR rate to compute the basic cost of capital. A positive relationship is expected between accounts receivable level and level of interest rate. The reason behind this can be the demand for trade credit which can be expected to be high when the cost of alternative capital is increased. An insignificant coefficient is found in the results Table 1 with value of (p= 0.59654834).

• Growth

Normally firm’s target growth rates are attached with its trade credit policies.

Generally, credit conditions just as discounts and duration of payments play a role of competitive instruments. In order to increase sales, firm may select a policy of offering trade credit with delayed due periods than its competitors are offering. This proposes that there is a positive relationship between growth and the level of accounts receivable. Though, trade credit may be used to boost sales of those firms which could not maintain a smooth rise in their sales. Even in conditions of declining sales a firm may offer more trade credit than an average company in the industry (Petersen and Rajan, 1997).This study computes growth by the annual sales growth percentage. Empirically, it is found that sales growth is insignificant (p= 0.766271766) which can be interpreted as the sales growth does not affect the level of trade credit offered.

5.2. DETERMINANTS OF ACCOUNTS PAYABLE (TRADE CREDIT)

Firms generally make purchases from other firms on credit, recording the debt as an account payable. Accounts payable, or trade credit, is the largest single category of operating current liabilities, representing about 40% of the current liabilities of the average US nonfinancial corporations. The percentage is somewhat larger for smaller firms. Because small companies often do not qualify for financing from other sources, they rely especially heavily on trade credit. Table

2 presents the outcome of proposed determinants on which the accounts payable is regressed. This model uses the same variables (including the control variables) used for accounts receivable model. Besides these variables, two more variables


Service Management System are added in this model. First, to determine the asset maturity RATIO OF

CURRENT ASSETS (INVENTORIES AND FINANCIAL ASSETS) TO TOTAL

ASSETS is used. Second, to assess the supply of trade credit PURCHASES TO

TOTAL ASSETS is used.

•

Supply of Trade Credit

Niskanen and Niskanen (2000) use the annual purchases as a proxy for the supply of trade credit making an assumption that all purchases are on credit.

They believe that this assumption is not very restrictive, as large companies normally do not pay their purchases in cash. This study also uses the purchases as proxy to supply of trade credit and considers the same assumption. The result relating the supply of trade credit is same as expected: a significant and positive coefficient is obtained (p= 0.0005) which indicates that an increase in the supply of trade credit increases the level of its use.

• Creditworthiness and Access to Capital Markets

Result concerning asset size is quite significant in explaining the accounts payable level. The coefficient is positive and significance level is also quite high

(p= 0.0000). This positive sign shows that financing of larger firms is comprised of more trade credit than smaller firms. This may be due to their greater access to capital markets. This finding is consistent with Niskanen and Niskanen

(2000) where as Petersen and Rajan (1997) found a weak positive relationship between the firm size and accounts payable.

Model No AP = β0 + β1GR + β2CA + β3SIZE + β4KIB +

II:

Table 2: Dependant Variable:

β5CF + β6PUR

Accounts Payable

β

0

β

1

β

2

β

3

β

4

β

5

β

6



1 1

-

Coefficien 1273.16

0.84828

t 1 6

89.4942

0.26570

-

2.22140

9

225.909

2

14.8522

9.69028

8

2.51317

0.10307

0.426306

7

0.02944

S.E

1 5 0.592596

0.156219

1

P-Value (0.0000) (0.0015) (0.0002) (0.0000) (0.0001) (0.0066) (0.0005)

0.64379

R-Square

Adjusted-

R 2

0

0.63970

4

0.83927

F-Value 157.5394*

(0.000

)

DW

*Significant at

α = 0. 01 **

6

Significant at

α = 0. 05

•

Growth

Theory suggests that healthier investment opportunities are available to the firms which are growing and these firms require increased financing for these new investment opportunities. It is assumed that trade credit may be used as fractional source of financing for these growing firms. However, opposite is found from empirical results. Sales growth is found to have a negative but significant coefficient (p= 0. 0015) which implies that faster a firm is growing the less it uses trade credit in its financing. Hence, firms growing slowly or not growing at all utilize the trade credit most. Furthermore, these results are


Service Management System consistent with Niskanen and Niskanen (2000) and contradictory to the findings of Rajan and Zingales (1997).

• Internal Financing

The results reveal that operating cash flow is a significant variable in explaining the accounts payable level with p-value of (p= 0066).

• Asset Maturity

In explaining the level of accounts payable the asset maturity, measured by the ratio of current assets to the total assets, is found to have a greater proportion with a significant positive variable (p= 0002). This finding is consistent with the view that firm’s assets are financed with funds having same maturities. This is carried out to plan repayments of the funding to match with the decline in the value of firm’s assets (Diamond, 1991). As a result, short-term assets are usually financed with short-term debt just as accounts payable, while long-term assets are financed with long-term debt or equity.

• Cost of Alternative Capital

Market interest rate, measured as average 3 month KIBOR rate, is appeared to be quite significant explanatory variable in explaining accounts payable (p=

0001). Positive coefficient of market interest rate shows that higher the interest rates the higher the demand for trade credit will be. As it is vivid from the results that market interest rate is not significant in accounts receivable model, this may support the idea that demand side is more affected by the fluctuations in the market interest rate.

• CONCLUSION

This study empirically analyzed the determinants of Pakistani listed firms accounts receivable and accounts payable management policies. The results show that accounts receivable are strongly affected by the firms’ incentive to use trade credit as a means of price discrimination and level of internal


Service Management System financing. Furthermore, size of the firm also affects the level of accounts receivable a firm maintains. The results of the accounts payable model show that all the variables, which were taken to determine the level of accounts payable, were statistically significant. Additionally, most significant determinants of accounts payable were size of the firm, level of purchases and market interest rate. Dissimilarity in the results of this study to earlier studies may greatly be due to the variation among Pakistani, U.S., UK and Finnish capital markets. As it is evident, that ban-borrower relationship, when analyzed as financial intermediaries, is supposed to be a substitute source of capital for trade credit. This relationship can be studied as further research line in this area. But the unavailability of data on this relationship makes it bit a difficult task as statistics regarding relationship between banks and firms are not publicly available.

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Credit. Financial Management, 36 (1), 49-67.

Blasio, G. (2005). Does Trade Credit Substitute Bank Credit? Evidence from Firm ‐ level Data. Economic notes, 34(1), 85-112.

Brennan, M. J., Miksimovic, V., & Zechner, J. (1988). Vendor financing. The

Journal of Finance, 43 (5), 1127-1141.

Brick, I. E., & Fung, W. K. H. (1984). Taxes and the theory of trade debt.

Journal of Finance , 1169-1176. Danielson, M. G., & Scott, J. A. (2004). Bank loan availability and trade credit demand. The Financial Review,

39 (4), 579-600.



Deloof, M., & Jegers, M. (1999). Trade credit, corporate groups, and the financing of Belgian firms. Journal of Business Finance & Accounting, 26(7 ‐

8), 945-966.

Diamond, D. W. (1991). Monitoring and reputation: The choice between bank loans and directly placed debt.

Journal of Political Economy , 689-721.

Emery, G. W. (1984). A pure financial explanation for trade credit. Journal of financial and quantitative analysis, 19 (3), 271-285.

Emery, G. W. (1987). An optimal financial response to variable demand.

Journal of financial and quantitative analysis, 22 (02), 209-225.

Ferris, J. S. (1981). A transactions theory of trade credit use. The Quarterly

Journal of Economics, 96 (2), 243. Frank, M., & Maksimovic, V. (1998). Trade credit, collateral, and adverse selection. Unpublished manuscript,

University of Maryland .

Hill, N. C., & Sartoris, W. L. (1988). Short-term financial management : Macmillan.

Huyghebaert, N. (2006). On the Determinants and Dynamics of Trade Credit

Use: Empirical Evidence from Business Start ‐ ups. Journal of Business

Finance & Accounting, 33(1 ‐ 2), 305-328.

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–98.

Lee, Y. W., & Stowe, J. D. (1993). Product risk, asymmetric information, and trade credit. Journal of financial and quantitative analysis, 28 (02), 285-300.



Long, M. S., Malitz, I. B., & Ravid, S. A. (1993). Trade credit, quality guarantees, and product marketability.

Financial Management , 117-127.

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1619-1630.

Meltzer, A. H. (1960). Mercantile credit, monetary policy, and size of firms. The

Review of Economics and Statistics, 42 (4), 429-437.

Mian, S. L., & Smith Jr, C. W. (1992). Accounts receivable management policy:

Theory and evidence. Journal of Finance , 169-200.

Myers, S. C. (1984). Capital structure puzzle: National Bureau of Economic

Research Cambridge, Mass., USA. N. Berger, A., & F. Udell, G. (1998). The economics of small business finance: The roles of private equity and debt markets in the financial growth cycle. Journal of banking and finance, 22 (6-

8), 613-673.

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The roles of private equity and debt markets in the financial growth cycle.

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Finnish Journal of Business Economics , 489-503.

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Credit Policies in a Bank ‐ dominated Financial Environment: the Case of

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Author: Mubashir Ali Khan

Title: Determinants of Accounts Receivable and Accounts Payable: A Case of

Pakistan Textile Sector

URL: www.journal-archieves14.webs.com/240-251.pdf

Date Published: January 2012



9 TH INTERNATIONAL ASECU CONFERENCE ON

“SYSTEMIC ECONOMIC CRISIS: CURRENT ISSUES AND PERSPECTIVES”

Ksenija Denčić-Mihajlov

University of Niš, Faculty of Economic, Serbia

IMPACT OF ACCOUNTS RECEIVABLE MANAGEMENT ON THE

PROFITABILITY DURING THE FINANCIAL CRISIS: EVIDENCE FROM SERBIA

UDC:658.155(497.11)

Abstract:

The competitive nature of the business environment requires firms to adjust their strategies and apply financial policies to survive and enable growth. In most firms, receivables represent large financial sources invested in asset and involve significant volume of transactions and decisions. This paper investigates how public companies listed at the regulated market in the Republic of Serbia manage their accounts receivables during the recession times. A sample of 108 firms is used, which are the most successful Serbian firms listed at the Prime and Standard Listing as well as the

Multilateral Trading Platform of the Belgrade Stock Exchange. The accounts receivables policies are examined in the crisis period of 2008-2011. In order to explore the relation between accounts receivables and firm’s profitability, the short-term effects are tested.

The study shows that between accounts receivables and two dependent variables on profitability, return on total asset and operating profit margin, there is a positive but no significant relation. This suggests that the impact of receivables on firm’s profitability is changing in times of a crisis.

Key words : accounts receivable, profitability, management, financial crisis, Belgrade

Stock Exchange.



1. Introduction

Accounts receivable measures the unpaid claims a firm has over its customers at a given time, usually comes in the form of operating line of credit and is mainly due within a relatively short time period (up to one year). The volume of accounts receivable indicates firm's supply of trade credit while accounts payable shows its demand of trade credit. The study of accounts receivable and accounts payable during periods of financial crisis is an important topic, particularly when the global economy is going through a credit shock. During global financial crisis, characterized by high liquidity risk faced by the banks, trade credits may increase, operating as a substitute for bank credits, or decrease - acting as their complement. Bastos and Pindado (2012), for example, suggest that credit constraints during a financial crisis cause firms holding high levels of accounts receivable to postpone payments to suppliers, which act in the same manner with their suppliers. This gives rise to a trade credit contagion in the supply chain characterized by a cascading effect. The current financial crisis provides economists a unique opportunity to study the role of alternative financial sources during periods of breakdown of institutional financing.

Accounts receivables are one of the most important part of working capital. Receivables often represent large investment in asset and involve significant volume of transactions and decisions. However, there are considerable differences in the level of receivables in firms around the world. Demirgüç-Kunt and Maksimovic (2001)present evidence that in countries such as France, Germany, and Italy accounts receivable exceeds a quarter of firms' total assets, while Rajan and Zingales (1995) find that 18% of the total assets of

US firms consists of receivables. In different theories, the existence of receivables is explained by commercial reasons, transaction-cost motivations, and financial incentives

(Bastos & Pindado, 2007; Deloof & Jegers, 1999; Marotta, 2005; Petersen & Rajan,

1997).Accounts receivable management is a crucial filed of corporate finance because of its effects on a firm’s profitability and risk, and consequently on the firm's value. Yet, the main body of the literature of accounts receivables focuses on studying the relation with firm’s profitability at the developed capital markets and during the non-crisis period.



Understanding the effects of a financial crisis on receivables management is especially important to Serbia as a transition country. Trade credit is an important source of finance for Serbian firms and, therefore, it can make a strong contribution to firms' profitability and the development of the whole economy. In this context, the aim of this paper is to examine the impact of accounts receivable management on the profitability of the Serbian companies during the financial crisis, in the period 2008-2011. The study investigates whether companies have to change their non-crisis accounts receivables management policies when the economy is into a recession. In order to test the relation between accounts receivables and a firm’s profitability, the short-term effects will be tested in times of a crisis.

The contribution of the paper is twofold. Firstly, it extends the existing empirical literature on relationship between firm's profitability and accounts receivables in developing and transitional economies in the crisis period, by focusing the analysis on the Serbian listed firms where, up to now, no research has been conducted. Secondly, this study verifies some of the previous findings by testing the relationship between accounts receivables management and the profitability of the sample firms, and thus broadens the possibilities for cross-country comparisons in the field of profitability determinants.

The structure of this paper is as follows. In Section 1,a summary of previous research on the effects of accounts receivable management on firm's profitability is given. In the next section we describe the sample, define the measures of profitability as well as the explanatory variables, and finally, test the potential determinants of on profitability. In

Section 3we provide conclusions, emphasise some limitations of the study and propose the objectives of future research.

2. Literature review

The goal of accounts receivables management is to maximize shareholders wealth.

Receivables are large investments in firm's asset, which are, like capital budgeting


Service Management System projects, measured in terms of their net present values (Emery et al., 2004).

Receivables stimulates sales because it allows customers to assess product quality before paying, but on the other hand, debtors involve funds, which have an opportunity cost. The three characteristics of receivables – the element of risk, economic value and futurity explain the basis and the need for efficient management of receivables.

According to Berry and Jarvis (2006) a firm setting up a policy for determining the optimal amount of account receivables have to take in account the following:

The trade-off between the securing of sales and profits and the amount of opportunity cost and administrative costs of the increasing account receivables.

The level of risk the firm is prepared to take when extending credit to a customer, because this customer could default when payment is due.

The investment in debt collection management.

Academicians have studied accounts receivable individually, but mostly as a part of working capital management, from various points of view. Bougheas et al. (2009), for example, focuses the research on the response of accounts receivable to changes in the cost of inventories, profitability, risk and liquidity. The other authors explore the impact of an optimal receivables management, i.e. the optimal way of managing accounts receivables that leads to profit maximization. Researches realized by Deloof

(2003), Laziridis and Tryfonidis (2006), Gill et al (2010), Garcia-Teruel and Martinez-

Solano (2007), Samiloglu and Demirgunes (2008) andMathuva (2010) done in Belgium,

Greece, USA, Spain, Turkey, and Kenyarespectively, all point out to a negative relation between accounts receivables and firm profitability (Table 1). In other words, having an accounts receivable policy which leads to a low as possible accounts receivables has as a result the highest profitability. Contradicting evidence is found by Sharma and

Kumar (2011), who find a positive relation between ROA and accounts receivables.



Table 1 Summary of previous research on the effects of receivables turnover on firm’s profitability

Research

Deloof (2003)

Lazaridis and

Tryfonidis (2006)

Gill et al (2010)

Sample, period Type of relation

1009 large Belgian non-financial firms for the Significant negative

1992-1996 period relation on

131 companies listed in the Athens Stock

Exchange (ASE) for the period of 2001-2004 profitability

Significant negative relation on profitability

88 American firms listed on New York Stock Significant negative

Exchange for the period 2005 - 2007 relation on profitability

García-Teruel and

8,872 Spanish SMEs for the period 1996-2002 Significant negative

Martínezrelation on

Solano(2007)

Samiloglu and Istanbul Stock Exchange (ISE) listed

Demirgunes (2008) manufacturing firms for the period of 1998-2007

Mathuva (2010) profitability relation on profitability

Significant negative

30 firms listed on the Nairobi Stock Exchange Significant negative

(NSE) for the periods 1993 to 2008 relation on profitability

Sharma and Kumar 263 non-financial BSE 500 firms listed at the Significant positive

(2011) Bombay Stock (BSE) from 2000 to 2008 relation on

Baveld (2012) profitability

37 large firms in The Netherlands, during the Significant negative non-crisis period of 2004-2006 and during the relation on

Financial Crisis of 2008 and 2009 profitability

However, the main body of the literature of accounts receivables focuses on studying in the environment of developed capital markets and during the non-crisis period. The consequences of a financial crisis on receivables is of enormous relevance, since a crisis causes trade credit contagion as a consequence of financial contagion between financial intermediaries (Bastos and Pindado, 2012). Researches on trade credit during financial crises are done in case on Japan's crisis (Fukuda et al., 2006), for the Asian crisis (Love et al 2007) and for the recent global financial crisis (Yang, 2001, Bastos


Service Management System and Pindado, 2012). As to researches that study relationship between profitability and accounts receivables during current global crisis period, it is worth mentioning the study done by Baveld (2012). It this study that investigates how public listed firms in The Netherlands manage their working capital, two periods are compared - the non-crisis period of 2004-2006 and the financial crisis period of 2008 - 2009.

Baveld's study indicate a statistically significant negative relation between accounts receivables and gross operating profit during non-crisis period. On the other hand, during crisis period, no significant relation between these two variables is observed.

This result may suggest that the relation between accounts receivables and firm’s profitability is changed in times of a crisis in the way that some firms should not keep their accounts receivables at minimum in order to maximize profitability during crisis periods.

Taking into consideration the results of study done by Baveld (2012) and the others above mention studies, the aim of this research is to examine the impact of accounts receivable management on the profitability of the Serbian companies during the financial crisis, in the period 2008-2011.

3. Empirical Analysis

3.1 Sample and Data Description

We tested the regression model of profitability on the sample consisting of real-sector publicly traded companies whose shares are quoted on the regulated market of the

Belgrade Stock Exchange. We compiled the basis of financial statements (source:

Serbian Business Registers Agency - SBRA) for those publicly-listed companies that were quoted in all the segments of regulated stock exchange market, that met the size criterion in all analyzed years (meaning big or medium enterprises) and operated in real sector (financial firms are excluded from the sample). In such an initial stadium of defining the sample, we had 432 firms in total. After the Decision on Stock Exchange

Reorganization, brought on 27/04/2012, we excluded from the sample all the companies shifted from OTC market to be quoted in MTP ( Multilateral Trading Platform ) segment,


Service Management System since they did not belong to Regulated market and were not active in the previous 180 days regarding share trading of the particular issuer. We also excluded companies with consolidated financial statements in any of the analyzed years, as well as those companies whose loss was over the amount of capital so that they were practically financed only from borrowed sources, and accordingly, the value of financial leverage equals one.

The sample contains the financial data for 4 years in sequence, in period from 2008 to

2011. The final sample, representing the basis for the empirical study, comprises a total of 108 big and medium publicly-listed non-financial companies, whose shares are quoted on the regulated segment of the Belgrade Stock Exchange. These companies are mostly the result of mass corporatization in Serbia at the beginning of 21st century, as a part of the process of Serbian transition to market economy and private property.

The most significant share in the sample structure by the criterion of sector or business belongs to companies from processing industry (52%), agriculture, forestry and fishing

(14,9%), transportation and storage (10,2%) and construction (8,4%).Financial statements of these companies are prepared following the International Accounting

Standards (IAS), or International Financial Reporting Standards (IFRS).

Total number of observations for each variable is 432 (108*4). When we consider the four-year value average or the value for one year only, total number of observations is

108. We have processed the data from companies’ financial statements and calculated dependent and independent variables within the regression model, which is defined in the following text.

3.2. Descriptive statistics

The ratio analysis mainly uses two types of profitabilitymeasures – margins and returns.

Margins ratios(Gross profit margin, Operating profit margin, Net profit margin, Cash-flow margin)describe the firm's ability to translate sales into profits at various stages of measurement. Ratios that calculate returns represent the firm's ability to measure the


Service Management System overall efficiency of the firm in generating returns for its shareholders (Return on asset,

Return on equity, Return on capital, Cash return on assets and so on). Many different measurements of firm profitability are used by the researchers who studied the relation between accounts receivable and profitability. The simplest and the most used ratio, that relates the profitability of a company with its assets, is Return on Assets (ROA). It is calculated as net income divided by total assets.

Two profitability measures are used in this study: Operating Profit Margin (OPM), calculated as operating profit divided by total assets and Return on Total Assets

(ROTA) calculated as earnings before interest and tax divided by total assets. ROTA measures the ability of general management to utilize the total assets of the business in order to generate profits, while Operating Profit Margin shows the profitability of sales resulting from regular business. Operating income results from ordinary business operations and excludes other revenue or losses, extraordinary items, interest on long term liabilities and income taxes.

The descriptive statistics of two profitability measures and explanatory variables are reported in Table 2, while the correlation matrix is presented in Table3. The measures of profitability, as well as the explanatory variables (receivables turnover ratio, accounts receivable to revenue ratio, size and liquidity), are averaged for the period 2008-2011.

Size is the natural logarithm of net sales. Liquidity is measured by current ratio (current assets/current liabilities). Receivables turnover ratio measures the average period for which sales revenue will be held in accounts receivable. This ratio is usually used to describe the efficiency and effectiveness of receivables collection. The trends in accounts receivable to revenue ratio highlight tendency in the degree of investment in accounts receivable.

The results of dependent variables, Return on Total Assets (ROTA) and Operating

Profit Margin (OPM), exhibit that the mean of ROTA (OPM) of all firms analyzed is

0.047 (0.032). The distribution of ROTA is positively skewed, with kurtosis of 0.083, which describes that the scores for the ROTAs are clustered around the mean in the


Service Management System right-hand tail. On the other hand, the distribution of OPM is negatively skewed, with kurtosis of 17.716, which indicates that the more peaked distribution is skewed to the left. It can be observed that the profitability of Serbian companies whose shares are traded on a regulated market is not at a significant level. But, having in mind the analyzed crisis period, the fact that they still operate in profit zone is indicative.

The average number of days accounts receivables for the Serbian companies listed at the regulated market is 69,5 days. This is far below the value of RTR of the whole

Serbian economy in 2011, which is, according to Euro stat data, 128 days. The natural consequence of crisis environment is a conservative behavior of Serbian companies.

The most significant crisis effect is related to corporate growth and is reflected in the fact that companies postpone planned investments. All the attention is concentrated on providing cash, given that the real sector is primarily faced with liquidity risk, and the need for working capital is increasing in time of crisis. The difficulties in collection of receivables are becoming serious as the crisis progresses. The value of receivables turnover ratio continually increases in the analyzed crisis period, starting from 66, 4 days in 2008, and reaching 73,1 days in 2011. The increase in input prices and increased exchange rates, together with the problematic collection of receivables affected the operating result.

Table2 Summary statistics

Mean

Median

Std. Deviation

Variance

Skewness

ROTA OPM ARRR RTR SIZE LIQ

,044636 ,032373 ,194138 69,50925 5,864046 2,400914

,035425 ,03137716 ,143752 51,50000 5,816000 1,587933

,067246 ,13817079 ,136127

48,26746

,492433 2,478863

,005 ,019 ,019 ,100 ,242 6,145

,369 -2,883 1,120 1,151 ,408 2,850



Std. Error of Skewness

Kurtosis

Std. Error of Kurtosis

Minimum

Maximum

,233 ,233 ,233

,083 17,716 ,692

,461 ,461 ,461

,233

,867

,461

,233

,016

,461

,233

9,891

,461

-,109028 -,846249 ,027984 10,0000 4,696000 ,233524

,220683 ,377185 ,625985 228,000 7,255000 15,843705

The average value of accounts receivable to revenue ratio describes the accounts receivables management of Serbian companies in the crisis time too. The value of this ratio for the sample is 19,41%, telling that almost 20% of total sales revenue is related to the unpaid sales. As the crisis progresses, from 2008 to 2011, the value of ARRR increases (from 18% to 20,4%), indicating that the amount of cash that is tied up with the slow paying customers is growing. Yet, this numbers are still below the share of receivables in the net revenue of 25% evidenced in France, Germany, and Italy by

Demirgüç-Kunt and Maksimovic (2001).

The results on the average collection period for Serbian companies are higher than the findings of some studies done in non-crisis period. Deloof (2003) find an average of

RTR of 54,64 days in Belgium, Gill et al. (2010) of 53,48 days in the US. On the other hand, Garcia-Teruel and Martinez-Solano (2007) present evidence on the average receivables turnover ratio for Spanish firms of 96,82 days, Samiloglu and Demirgunes

(2008) and Lazaridis and Tryfonidis (2006) findaverage receivables turnover ratio in

Turkey and Greece is 139,07 and 148,25 respectively.

Table 3 shows correlation coefficients of all variables. ROTA and OPM are dependent variables. Concerning the explanatory variables, relatively high correlation coefficients

(higher than 0.5) are observed only in case of ARRR and RTR.The results of the correlation analysis shows that the number of days accounts receivables as well as accounts receivable to revenue ratio positively relate to both the dependent variables -


Service Management System return on total assets and operating profit margin. This indicates that in crisis time, a higher level of accounts receivables could induce a higher profit in the Serbian case.

Contradicting evidence is found with the correlation analysis of Bavald (2009), who finds a negative relation between the number of days accounts receivables and a firm’s profitability in the crisis time in the case of the Netherlands. The results of Bavald's correlation analysis show a negative relation between the number of days accounts payables and both return on assets and gross operating profit. This indicates that managers can create value by keeping the levels of accounts receivables to a minimum.

Table3 The correlation matrix of profitability and independent variables

ROTA

OPM

ARRR

ROTA OPM ARRR RTR SIZE LIQ

1

(,680)** 1

(,329)** ,142 1

RTR (,293)** ,127* (,959)** 1

SIZE

LIQ

(,385)** (,436)** (,283)** (,253)*

(,298)** (,405)** -,116 -,059 ,086

1

1

**Correlation is significant at the 0.01 level (2-tailed).

*Correlation is significant at the 0.05 level (2-tailed).

Sales and liquidity show also a positive relation on the dependent variables, which is consistent with the findings of Deloof (2003), and Baveld (2012). A shortcoming of

Pearson correlations, that they are not able to identify the causes from consequences(Deloof, 2003), will be overcome by the regression analysis.



3.3 Regression model

The regression analysis used in this study is based on the following equations:

• OPM it

= β

0

+ β

1

ARRR it

+ β

2

RTR it

+ β

3

SIZE it

+ β

4

LIQ it

+ε it

• ROTA it

= β

0

+ β

1

ARRR it

+ β

2

RTR it

+ β

3

SIZE it + β

4

LIQ it

+ε it where OPM and ROA measures the firm profitability, SIZE, the company size as measured by natural logarithm of sales, ARRR, the accounts receivable to revenue ratio, RTR, receivables turnover ratio, LIQ, the current liquidity ratio. The analysis utilizes fixed effect regression model for the whole sample (Table 4).

The results of regression analysis indicate a positive relation between accounts receivables and return on total assets, which is not statistically significant. Table 4 also shows a stronger, but positive relation between accounts receivables and the second dependent variable

– operating profit margin. This finding is not surprising taking into account that operating profit margin describes the profitability of sales resulting from the core business, which is highly influenced by the amount of receivables and the collection effectiveness.

As it is pointed out by Baveld (2012), the absence of any significant relation for both the dependent variables may indicate that the relation between accounts receivables and firm’s profitability is changed in times of a crisis. These regression results could be explained by the fact that Serbia is an transition and emerging market where most of the firms are seen more profitable if they give their clients more trade credit. Indeed, these finding are contradicting with the results on the impact on receivables on firm's profitability in many developed counties (see Table 1), but consistent with Sharma and

Kumar (2011), who also find a positive relation between ROA and accounts receivables in the case of India. The conclusion can be made that large and medium


Service Management System listed firms in Serbia use to keep their levels of accounts receivables to a high level during crisis years.

Table 4 Regression model results for two dependant variables:

Return on Total Asset and Operating Profit Margin

Dependent variable: ROTA Dependent variable: OPM

Independent variable

Std.

tStd.

t-

Coeff.

Error statistic Sig.

Coeff.

Error statistic Sig.

(Constant)

ARRR

RTR

SIZE

LIQ

Weighted statistics

R square

Adjusted R square

SE regression of

-,280* ,085

,056 ,093

,041 ,039

,038* ,012

,008* ,002

,300

,273

,057

F-statistic 11,033

* Significant at 5% level

-3,281 ,001 -,908 ,167 -5,445 ,000

,601 ,549 ,306 ,181 -1,686 ,095

1,042 ,300 ,184 ,077 2,397 ,018

3,219 ,002 ,108* ,023 4,659 ,000

3,545 ,001 ,020* ,004 4,525 ,000

,367

,343

,112

14,937

Table 4 shows that R-squared value is 0.300 (0.367) indicating that 30% (36.7%) variance in Return on Total Assets ( Operating Profit Margin) as dependent variable can be explained through four independent variables used.

4.Conclusion



This study explores how large and medium sized companies listed at the regulated market segment of the Belgrade Stock Exchange manage their accounts receivables in the most profitable way during a crisis period, from 2008 to 2011.The analysis of the relation between accounts receivables and two dependent variables on profitability, return on total asset and operating profit margin, indicates a positive, but no significant relation. This implies that managers of the most successful Serbian companies are of the opinion that it’s profitable, and thus beneficial for their firms, to support their financially constraint customers by increasing the level of the receivables. In this way, companies secure their future sales and survival in crisis times. Companies take into account the trade-off between extending trade credits and increasing the default risk involved on the one hand, and the short-term and the long-term benefits of such a receivables management on the other hand. Profitability and creation value for shareholders over crisis time is achieved by increasing the accounts receivable levels.

This study is featured at least by three main limitations. In the first place, it is based on the data of the Serbian non-financial firms listed at the regulated market. Therefore, a generalization of the results of this research for the whole economy (financial firms, non-listed firms) is not acceptable. Secondly, the analysis is limited to a four-year crisis period, not taking into account the impact on receivables on profitability in a previous, non-crisis period. It this way, a comparative approach could not be applied and the differences between non-crisis and crisis period could not be compared and highlighted.

Finally, the correlation and regression analysis is conducted using the Return on Total

Assets and Operating Profit Margin as dependent variables, and four independent variables. In this respect, future research should comprise a more comprehensive set of explanatory variables and should be based on a larger and comprehensive database.

REFERENCES

Bastos, R., and Pindado, J. (2012), Trade credit during a financial crisis: A panel data analysis , Journal of Business Research (2012), doi:10.1016/j.jbusres.2012.03.015



Baveld, M. B. (2012), Impact of Working Capital Management on the Profitability of

Public Listed Firms in The Netherlands During the Financial Crisis.

http://purl.utwente.nl/essays/6152 4

Berry, A. AndJarvis, R. (2006), Accounting in a Business Context , Cengage

Learning EMEA, Andover, UK.

Bougheas S.,Mateut, S, and Mizen, P. (2009), Corporate trade credit and inventories:

New evidence of a trade-off from accounts payable and receivable , Journal of Banking and Finance 33, 300 –307.

Deloof, M. (2003), Does Working Capital Management Affect Profitability of Belgian

Firms ?, Journal of Business Finance & Accounting, 30(3-4), 573 – 587.

Deloof, M. and Jeger, M. (1996), Trade Credit, Product Quality, and Intragroup Trade:

Some European Evidence , Financial Management, 25(3), 945-968.

Demirgüç-Kunt, A., and Maksimovic, V. (2001), Firms as financial intermediaries:

Evidence from trade credit data , World Bank Working Paper 2696

Emery, D. Finnerty, J. And Stowe J. (2004), Corporate Financial Management ,

Pearson, Prentice Hall, New Jersey

Fukuda, S., Kasuya, M., and Akashi, K. (2006), The role of trade credit for small firms:

An implication from Japan's banking crisis , CIRJE Discussion Papers Series F-440.

Tokyo, Japan: The University of Tokyo.

Garcia-Teruel P.J. and Martinez-Solano, P.M. (2007), Effects of working capital management on SME profitability , International Journal of Managerial Finance, 3, 164-

177.



Gill, A., Biger, N. and Mathur, N. (2010), The Relationship Between Working Capital

Management And Profitability: Evidence From The United States , Business and

Economics Journal, Volume 2010: BEJ-10

Lazaridis, I. and Tryfonidis, D. (2006), Relationship Between Working Capital

Management and Profitability of Listed Companies in the Athens Stock Exchange ,

Journal of Financial Management and Analysis, 19(1), 26-35.

Love, I., Preve, A. P., and Sarria-Allende, V. (2007), Trade credit and bank credit:

Evidence from recent financial crises , Journal of Financial Economics, 83, 453 –469.

Marotta, G. (1997), Does trade credit redistribution thwart monetary policy? Evidence from Italy , Applied Economics, 29, 1619 –1629.

Mathuva, D. (2010), The Influence of Working Capital Management Components on

Corporate Profitability: A Survey on Kenyan Listed Firms, Research Journal of Business

Management, 4, 1-11.

Petersen, M. A. and Rajan, R. G. (1997), Trade credit: theories and evidence , Review of

Financial Studies, 10, 661

–692.

Rajan, R. And Zingales, L. (1995), What do we know about capital structure? Some evidence from international data , Journal of Finance, 50, 1421

–1460.

Samiloglu, F. and Demirgunes, K. (2008), The Effects of Working Capital Management on Firm Profitability: Evidence from Turkey . The international Journal of Applied

Economics and Finance, 2(1), 44 – 50.

Sharma, A.K. and Kumar, S. (2011), Effect of Working Capital Management on Firm

Profitability: Empirical Evidence from India , Global Business Review, 12(1), 159 – 173.



Yang, X.(2011), The role of trade credit in the recent subprime financial crisis , Journal of

Economics and Business 63, 517 – 529.

Author: Dencic mihajov

Title: IMPACT OF ACCOUNTS RECEIVABLE MANAGEMENT ON THE

PROFITABILITY DURING THE FINANCIAL CRISIS: EVIDENCE FROM SERBIA

URL : http://www.asecu.gr/files/9th_conf_files/dencic-mihajlov.pdf

LMSB-04-0606-004

Internal Revenue Service

Factoring of Receivables

Audit Technique Guide (ATG)



NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.

This material was designed specifically for training purposes only. Under no circumstances should the contents be used or cited as sustaining a technical position.

Internal Revenue Services

Large and Mid-Size

Business Division

(LMSB) www.irs.gov

Publication Date (June 2006)

Factoring of Receivables Audit Techniques Guide

June 2006

NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.



Overview

Companies generate accounts receivable by selling goods or services to their customers on credit. Many companies who extend credit to their customers sell their accounts receivable to a factor. A factor is a specialized financial intermediary who purchases accounts receivable at a discount. Under a factoring agreement a company sells or assigns its accounts receivable to a factor in exchange for a cash advance. The factor typically charges interest on the advance plus a commission. The price paid for the receivables is discounted from their face amount to take into account the likelihood of un collectability of some of the receivables.

Factoring is a technique used by companies to manage their accounts receivable and provide financing. Typically companies that have access to sources of financing that is less expensive than factoring would not use factoring as source of credit.

A factor may provide any of the following services:

• Investigation of the credit risk of customers of the client;

• Assumption of the credit risk of customers;

• Collection of the client’s accounts receivable from customers;

• Bookkeeping and reporting services related to accounts receivable;

• Provision of expertise related to disputes, returns and adjustments;

• Advancing or financing.

There are numerous types of factoring arrangements. Some of the basic types vary the treatment of credit risk assumption and customer or debtor notification.

When the factoring agreement involves the purchase of accounts receivable where the factor bears the risk of a customer or debtor failing to pay the client for reason of financial inability it is a non-recourse or without-recourse agreement. In the situation


Service Management System where the client must bear the risk of non payment due to financial inability, the agreement is a recourse agreement. In many instances, factoring agreements provide for accounts to be purchased on both a recourse and non-recourse basis depending on the credit worthiness of the customers or the debtors.

Compliance Focus

A strategy has been identified in which multinational corporations use the factoring of accounts receivable among related parties. The goal of this strategy is to avoid U.S. taxation by shifting income offshore and to significantly reduce remaining U.S. income by deducting expenses related to the same income.

Typical Fact Pattern:

A U.S. subsidiary (“Taxpayer”) of a foreign parent earns sales income and books accounts receivable. The Taxpayer then factors (sells at a discount) the accounts receivable to a brother-sister foreign affiliate. The Taxpayer pays the foreign factor the following fees: a discount; administration fees; commissions; and interest.

The Taxpayer deducts these fees or may net them against gross receipts. However, the foreign factor does not perform any of the typical services of a factor, including collection of the Taxpayer’s accounts receivable. Instead, the

Taxpayer agrees to continue doing all or most of its own collection work on its accounts receivable. In some cases, factoring arrangements involve the use of a domestic (U.S. based) factor instead of a factor located offshore. In cases involving a domestic factor, some audit steps and issues discussed below may not apply. If the transaction is between two domestic entities it may be structured for state tax purposes and has no federal tax effect. In addition, in some cases, the Taxpayer and factor may be engaged in a financing arrangement involving securitizing the accounts receivable.



General Audit Steps

Although U.S. taxpayers are taxed on their worldwide income, the income of foreign subsidiaries of U.S. taxpayers is generally deferred from taxation in the U.S.

Consequently, the existence of a factoring arrangement may not be readily identified on the face of a return. Therefore, at a minimum the following audit steps should be utilized:

• Submit a specific IDR to determine if any accounts receivable were sold if yes, were they sold to:

• A related entity; and/or

• Any entity located offshore.

• Review the tax return balance sheet to determine if the accounts receivable reflected thereon are reasonable for the size and type of business.

• Perform a comparative analysis of the balance sheets for the current and at least 5 prior tax years, noting any significant reduction in accounts receivable.

• Review the tax preparation work papers for large debits to income.

• Review and analyze Form 5472 and the audited financial statements of both the domestic entity and the related foreign entity for any footnotes reflecting the sales and/or securitization of the accounts receivable. Request that the foreign entity provide this information in English. Note whether this analysis demonstrates income shifting from the domestic entity to the foreign entity. Also note whether there is evidence that the foreign entity was conducting a trade or business within the United States.

The following facts should be determined during the audit through IDRs or functional analysis and by requesting documentary substantiation where appropriate.

The Factor

Name and location of the factor;



• Relationship of the factor to the taxpayer;

• The name and location of a common parent of the factor and the taxpayer;

• Whether the taxpayer and the factor are part of a consolidated group;

• Whether the factor is a Controlled Foreign Corporation (CFC);

• The name of any promoter/advisor or accounting firm involved in structuring the taxpayer’s factoring arrangement.

The Factoring Arrangement

The factoring arrangement is usually set forth in a Factoring Agreement between the factor and the taxpayer. Obtain a description of the terms of the factoring arrangement including if applicable the following:

The names of the parties that entered into the Factoring Agreement;

• The date the Factoring Agreement was signed;

• The services the factor agreed to provide;

• The services the factor contracted back to the taxpayer;

• The fees the taxpayer charged the factor for performing the services contracted back to the taxpayer;

• The discount and fees charged by the factor for:

• discount on accounts receivable;

• administrative fees;

• commission fees;

• interest charges.

The date the taxpayer was required to transfer accounts receivable to the factor;

• The date the factor had until to accept or deny the factored accounts receivable;

• Whether the sale of the receivables to the factor was recourse or nonrecourse;

• The reasons the taxpayer provided for entering into the factoring arrangement;

• Whether the taxpayer ever entered a factoring arrangement before;



• Whether it is a common practice in the taxpayer’s industry to factor receivables;

• If a related entity is utilized to perform factoring, explain the source of the funding used by this entity to acquire the accounts receivable.

Securitization

If the factoring arrangement involves the securitization of factored accounts receivable then obtain a description of the securitization process including:

The purpose for securitizing the accounts receivable;

• The names and location of all entities involved in the securitization process;

• The relationship between the parties involved in the securitization arrangement;

• Whether any of the entities involved in securitizing the accounts receivable were a

Special Purpose Vehicle (SPV);

• The fees charged by the parties involved in securitizing the accounts receivable;

• A description of how the accounts receivable were securitized, including the flow of funds;

• Whether the sale of the receivables to the factor was recourse or nonrecourse;

• Whether the taxpayer ever securitized its accounts receivable before;

• Whether it is a common practice in the taxpayer’s industry to securitize accounts receivable;

• If a related entity is utilized to perform securitization, explain the source of the funding used by this entity to acquire the accounts receivable.

Tax Return

• Indicate where on the tax return the expenses from the factoring arrangements are deducted. Identify if the factoring fees are netted


Service Management System against other items such as sales. Also, indicate if the factoring deductions are reflected as book/tax difference on Schedule M.

• Provide all tax preparation work papers related to the factoring/securitization arrangement.

Financial Statements

Indicate if and how the factoring arrangements are presented on the taxpayer’s financial statements. Compare the treatment of how the factoring arrangements are presented on the financial statements with the presentation on the tax returns.

Transfer Pricing Studies

Taxpayers engaged in transactions with related parties are required to establish an appropriate transfer price in accordance with prescribed methodologies. Analysis and evaluation of the appropriate price is what is known as a Transfer

Pricing Study.

To obtain a copy of any and all Transfer Pricing Studies, prepare a separate IDR consisting of the following two paragraphs:

Please provide within 30 days of this request any principal documentation outlined in

Treas. Reg. Section 1.6662-6(d) (2) (iii) (B) that has been prepared to support your transfer pricing methodologies for all years under examination. This information would generally be provided in the form of a study; however all principal documentation outlined under the Code and associated Treasury

Regulation which was prepared for the years under examination, regardless of form, is requested. This documentation should include all internal and/or external studies.

It should be so noted that any documentation prepared by the taxpayer pursuant to

Section 6662(e) must be in existence when the return was filed in order to meet the documentation requirement. In addition, if this documentation is not provided within 30


Service Management System days of this request, and if there are significant adjustments to your transfer price as determined under IRC Section 482, a penalty may be applicable under IRC Section

6662(e) or (h).

Functional Analysis

When determining the appropriate amount of factoring fee charged between related parties, it may be necessary to perform a functional analysis to determine the actual services performed; the entity which performed the services; and, any compensation charged for these services.

A functional analysis prepared with respect to factoring arrangements should include, but not be limited to, the following:

Identity of the factor and its geographic location.

• Identity of the legal form (partnership, corporation, LLC, etc) of the factor

• Identity of the tax form (partnership, corporation, disregarded entity) of the factor.

• Identity of the functions performed by the factor; and, if appropriate, the functions which the factor contracts to be performed on its behalf.

• Identity of the number, names and location of any employees of the factor.

• Identity of duties specifically performed by each employee.

• Identity of who performs the factoring functions.

• Explanation, in detail, of any transfer pricing methodology used in determining how a related entity reimbursed the taxpayer for services provided (i.e. servicing rights).

• Explanation, in detail, of any risks assumed with regard to the factored receivables and the entity assuming such risks.

• Analysis, in detail, of the amounts attributable to these risks, to be supported by appropriate work papers.

Bad Debt History



Determine the bad debt history of the taxpayer’s accounts receivable for the years under exam and if possible the past 3 to 5 years. Calculate the percentage of receivables written off as bad debts for each of the years. Identify the first time that the taxpayer entered into a factoring arrangement and indicate the reasons the taxpayer provided for entering into such an arrangement.

Dates the Receivables Were Collected and Transferred

The legal analysis of factoring arrangements may require identifying the dates and amounts of receivables transferred to the factor. Accordingly, for all the factored receivables determine:

The dates and the amounts of the accounts receivable the taxpayer transferred to the factor.

The dates the taxpayer received collection on the accounts receivable; and

The dates the factor had until to accept or deny the transferred accounts receivable.

Prior History on Sale of Accounts Receivable/Repeal of Mark-To-Market

Treatment under Section 475/Tax Avoidance

Obtain answers to the following questions:

• Prior to July 1998, did the taxpayer utilize Section 475 to mark-to-market its accounts receivable?

• Did the taxpayer start or complete setting up transactions involving the



“sale” of its accounts receivable to related corporations after July, 1998?

• Were any of these corporations created or acquired around or after July,

1998 to carry out this sale of accounts receivable?

• Were any of these types of transactions set up and promoted/marketed by any of the accounting firms or other promoters/advisors?

• Were any of the valuation services (for the accounts receivable) provided by the same accounting firm which marketed the transaction? Who provided the valuation services?

Other

Obtain a copy of the Accounting Manual; Standard Operating Procedures and/or Flow

Charts which describe the corporate factoring/securitization policies and/or procedures.

• Obtain all legal, accounting, financial, and economic opinions and memoranda secured by or on behalf of the taxpayer in connection with this transaction.

• Determine whether a Tax Contingency reserve was established for any transactions.

• Obtain copies of any communications, brochures, memoranda or other materials received from or sent to the Taxpayer or its representatives describing the factoring arrangement.

Treas. Reg. section 6050P

Treas. Reg. section 6050P contains final regulations to the information reporting requirement under section 6050P of the Internal Revenue Code for discharges of indebtedness. The preamble of the Treas. Reg. section 6050P regulations, describe typical unrelated party pricing of factoring transactions and provide an example demonstrating how a bona fide unrelated party factoring transaction is often priced.

The preamble states that factoring between unrelated parties ordinarily involves a factor who performs the following functions:



Initial credit investigation;

• Selective assumption of the risk of loss (sometimes referred to as guaranteeing credit);

• On-going credit monitoring of the client’s customers, collection and bookkeeping .

The preamble states that for typical transactions with unrelated parties factoring fees range between 0.35 percent of the face value of the accounts receivable (if the client retains the collection function) and 0.70 percent of the face value (if the factor undertakes the collection function).

Accordingly, it may be indicative that a factoring arrangement between related parties is abusive if the factoring fees are much higher than the typical factoring fees charged for unrelated parties. This type of analysis should be made in determining whether a section 482 adjustment is warranted.

Typical Issues:

Potential issues include, but are not limited to:

Were there deemed dividends from the U.S. taxpayer to its foreign parent in the amount of collected accounts receivable transferred to the foreign factor; and, were withholding taxes due on the dividends paid to a foreign recipient?

Have the arm’s-length principles under section 482 been applied with respect to the sale of accounts receivable to a related party?

• Did the foreign factor’s factoring activities generate income from a trade or business within the United States?

• Should losses between the related parties in the factoring transaction be adjusted under Section 267?

• Was the factor a controlled foreign corporation (“CFC”) conducting intercompany transactions with the Taxpayer pursuant to Treas. Reg. 1502?



• Should losses from the factoring transaction be disallowed under Section 269 because the factor was acquired or created to evade or avoid income tax ?

Author:

Title: Internal Revenue Service Factoring of Receivables Audit Technique Guide (ATG)

URL: www.lrs.gov/pub/lrs-utl/tactoring of receivables atg final.pdf

Date Published: June 2006

JYRKI NISKANEN & MERVI NISKANEN

Accounts Receivable and

Accounts Payable in Large Finnish



Firms’ Balance Sheets: What

Determines Their Levels?

ABSTRACT

This study empirically examines the determinants of Finnish listed firms’ accounts receivable and accounts payable. The results show that accounts receivable are most likely to be affected by the firms’ incentive to use trade credit as a means of price discrimination. Increases in the interest rate level also increases the amount of accounts receivable through increased demand for trade credit. The most important determinants for the level of accounts payable appear to be the supply of trade credit, firm size, interest rate level, the ratio of current assets to total assets, and insufficient internal financing .

1 . INTRODUCTION

Official statistics show that Finnish manufacturin g companies’ accounts receivable are on aver-age 9.7% and accounts payable 6.1% of total asset

(firms with more than 20 employees). For retail firms the respective percentages are 8.1% and 16.0% and for wholesale firms the numbers are as high as 24.1% and 23%, respectively.

1 The importance of trade credit varies by country, and is likely to be highest in industrialized countries, although there is substantial variation across them (Marotta, 1997). Rajan and Zingales (1995) investigate non-financial firms in the G7 countries, and find that the proportional share of accounts receivable varies between 13% (Canada) and 29% (Italy), whereas the range for accounts payable is between 11.5% (Germany) and 17%

(France). It is thus apparent that accounts receivable may form a substantial fraction of a firm’s assets, and accounts payable may be an important source of outside funding. Several theories have been developed to explain trade credit


Service Management System use. However, firm level empirical evidence is scarce and it is all on U.S. data.

This paper tests the available theories using data on Finnish listed firms.

2 . THEORIES AND SOME EMPIRICAL EVIDENCE ON TRADE CREDIT

Several theoretical studies attempt to explain why suppliers provide financial intermediary services to their clients, and why these are willing to use trade credit instead of, e.g., bank debt even if trade credit is well known to be a more expensive source of funds.

Transaction costs have been stated to be one reason to maintain credit sales. Ferris

(1981) argues that the existence of trade credit allows flexibility in payments and makes it possible to cumulate the payments of several successive shipments to be paid at once thus leading to savings of transaction costs. Furthermore, trade credit allows the buyers to hold smaller cash balances and save money accordingly. Other versions of the transaction costs theories relate to seasonalities in the consumption pattern of the selling firm’s products (for a detailed de-scription, see Petersen and Rajan, 1997).

Financial models are based on capital market imperfections relating to information asymmetries. Schwartz (1974) suggests that firms with better access to the institutionalized capital market and with lower cost of financing will offer trade credit to firms with high costs when borrowing from financial intermediaries. As Schwartz points out, the institutional arrangement of trade credit enables established firms to help finance the growth of their customers. It may also be argued that trade credit can serve to mitigate c redit rationing while trade credit provides a signal on the buyer’s good quality to the financial intermediary (Frank and Maksimovic, 1998; Biais and Gollier,

1997).

2

Other financial models suggest that the seller has an advantage over financial intermediaries in information acquisition and controlling the buyer. In the Anglo-

Saxon countries, all these advantages relate to the closer and more ’physical’ relationship between the seller and the buyer than between the buyer and


Service Management System financial intermediaries. E.g., if the buyer does not pay in time, the supplier can threaten to cut off future supplies. A financial intermediary may not have such powerful tools in use, since the threat to withdraw future finance may not have an immediate effect on the buyer’s behavior (Petersen and Rajan, 1997).

Trade credit may serve as a means of price discrimination when law (e.g., the Robinson-Patman Act in the U.S.) prohibits companies from directly using different prices for different customers. This is possible when credit terms contain an early payment discount. Firms with market power are more likely to offer such terms (Brennan et al., 1988; Mian and Smith, 1992). Such firms are operating with a high contribution margin, and have a strong incentive to gather additional sales but without cutting the price to existing customers. Therefore, they offer trade credit that creditworthy customers will avoid because of its high price. On the other hand, risky customers will take the credit because it may still be cheaper than to borrow from other sources (Brennan et al., 1988; Petersen and Rajan, 1997).

Trade credit can be considered an implicit guarantee for the seller’s products. The idea is that the buyer is given time to become convinced on the quality of the product before he pays for it (Lee and Stowe, 1993). Frank and

Maksimovic (1998) argue that trade credit as a guarantee is likely to be of particular importance for small and less well established sellers.

Some studies discuss the effect of changing macroeconomic conditions on the use and terms of trade credit. Schwartz (1974) argues that trade credit reduces the efficacy of any given amount of monetary control, but also mitigates the discriminatory effects generated by restrictive monetary policy. When loan supply is constrained, larger firms with easier access to institutionalized capital markets can extend trade credit to smaller firms (Kashyap et al., 1993). Under those circumstances it can be expected that smaller firms are willing to extend


Service Management System the term of the offered trade credit because rising interest rates make trade credit a more competitive form of short-term financing.

As Petersen and Rajan (1997) point out, there is little empirical evidence on the above theories in addition to their own study. They use firm level data from the National Survey of Small Business Finances that was conducted in 1988 –

89, and find that firms use trade credit more when credit from financial institutions is not available. Their evidence also shows that well established suppliers might act as financial intermediaries by lending to firms with no access to the financial markets. The study further finds some evidence to support the theory that trade credit is used as a means of price discrimination.

There are several differences between ou r data set and Petersen and Rajan’s

(1997) data. One important difference is that between the Finnish and U.S. capital markets. The Finnish capital markets are bank-based and highly concentrated. A number of studies on relationship lending suggest that close bank-borrower relationships enhance credit availability. These studies also suggest that firms operating in concentrated as opposed to competitive markets have easier access to funds

(Petersen and Rajan, 1995; Boot and Thakor, 1999). One distinguishing feature of the bank-based systems is that banks monitor the performance of firms more closely than in the market-based systems such as that of the U.S., play an active part in the administration of many large corporations, and may even own substantial amounts of their share capital. Under the Finnish circumstances, this fact may provide banks a relative advantage over suppliers as opposed to the financial intermediaries in the U.S., and thus have an effect on the firms’ patterns of using trade credit in their short and intermediate term funding.

Second, we use time series data that allow us to test the determinants of trade credit over time, whereas Petersen and Rajan (1997) used a cross-sectional one-year sample. We include explanatory variables such as the interest rate level and yeardummies that cannot be used when the data are available for only one year. A third


Service Management System difference is that our data consist of firms that are among the largest in Finland, whereas Petersen and Rajan’s sample mainly consisted of small firms.

The study proceeds as follows. Section 3 describes the data sample used.

Section 4 presents the results on the determinants of accounts receivable and accounts payable. Section 5 concludes the study.

3 . DATA DESCRIPTION

The data sample consists of financial accounting data on firms that were listed on the Helsinki Stock Exchange either in the main list or in the OTC list during the research period 1989 – 1997. For some firms data are available for shorter periods. The entire sample size is 1018 observations from 121 firms.

Table 1 shows the time-series behaviour of median accounts receivable (divided by as-sets) in firm size quartiles during the research period. Table 2 reports the respective results for accounts payable. The data have been classified into firm size quartiles based on annual sales.

The relative amounts of trade credit offered and used remain quite stable during the research period, and neither accounts receivable nor accounts payable display a trend in time in any quartile of sales. However, there are certain differences in trade credit policies between the different quartiles. Especially, firms in the smallest sales quartile clearly have the smallest accounts receivable and accounts payable relative to assets, while differences between the three larger quartiles are smaller and less consistent. The relative difference between the lowest sales quartile firms and other firms is much larger for accounts payable. The lowest sales quartile firms borrow from suppliers on average only 50% compared to the



TABLE 1. Median accounts receivable to total assets: time-series behaviour in different firm size quartiles. The smallest firms are in quartile

< 0.25 and the largest firms in quartile > 0.75.

Years

Quartile of sales 1989 1990 1991 1992 1993 1994 1995 1996 1997 All years

< 0.25

0.25 – 0.50

0.50 – 0.75

> 0.75

0.108

0.101

0.102

0.068

0.099

0.106

0.102

0.091

0.119

0.102

0.133

0.151

0.129

0.151

0.142

0.177

0.170

0.164

0.148

0.149

0.162

0.146

0.125

0.117

0.130

0.133

0.148

0.147

0.128

0.138

0.135

0.134

0.125

0.128

0.129

0.130

0.147

0.141

0.162

0.136

All firms 0.138

0.134

0.119

0.123

0.131

0.132

0.144

0.140

0.143

0.133

TABLE 2. Median accounts payable to total assets: time-series behaviour in different sales quartiles.

The smallest firms are in quartile < 0.25 and the largest firms in quartile > 0.75.

Quartile of sales 1989 1990 1991 1992 1993 1994 1995 1996 1997 All years

< 0.25

0.25 – 0.50

0.50 – 0.75

> 0.75

All firms

Years

0.035

0.045

0.025

0.020

0.030

0.027

0.034

0.033

0.039

0.031

0.062

0.057

0.045

0.052

0.053

0.071

0.072

0.073

0.080

0.082

0.069

0.059

0.054

0.066

0.055

0.069

0.058

0.055

0.058

0.059

0.081

0.075

0.061

0.067

0.070

0.085

0.082

0.079

0.086

0.078

0.068

0.059

0.050

0.051

0.053

0.071

0.062

0.060

0.071

0.060


Service Management System median firm of the total sample, whereas the respective ratio when lending to customers is about 75%.

The result concerning the differences between large and small firms may not be quite generalisable because there in fact are only large firms in our sample in the context of the entire population of Finnish firms. However, also

Petersen and Rajan (1997) found that larger firms tend to offer more trade credit to their customers and they also hold larger balances of accounts payable. Their results were similar for a sample of large COMPUSTAT firms as well as for their primary sample consisting of small and medium sized firms.

Table 3 shows the median percentages of accounts receivable and accounts payable classified by industry. The data are divided into four industry categories (classification codes used by Statistics Finland since 1995 are in parentheses): manufacturing and mining (C, D), energy supply and construction (E, F), retail and wholesale firms (G, H) and other services (I, J,

K, O).

Firms in wholesale and retail industries have the largest accounts receivable and accounts payable (16.6% and 13.3%, respectively). Accounts receivable are an important part of assets (14.7%) also in manufacturing and mining firms, whereas the level of accounts payable in

TABLE 3. Accounts receivable and accounts payable by industry.

Industry (classification codes used by Statistics Finland are in parentheses)

Manufacturing and mining (C, D)

Median Median Median Median

Accounts collection accounts payment

Receivable period payable period to total assets (days) to total assets (days)

.147

56 .067

59



Energy supply and construction (E,

F)

Trade (G, H)

Other services (I, J, K, O)

Total

.079

.166

.095

.133

55

44

42

51

.041

.133

.042

.060

57

53

74

60 these firms’ balance sheets is only 6.7% of total liabilities. In general, it is true for all industries that firms hold more accounts receivable than accounts payable. The medians for the whole sample are 13.3% and 6%, respectively.

4 . R E S U L T S

We regress accounts receivable and accounts payable on variables that can be argued to be their determinants based on the theories discussed earlier. We shortly discuss the theoretical relevance of each variable while presenting the empirical results from the estimations. Table 4 first summarises the variables of primary interest and presents correlations between them.

3

4.1. Accounts receivable

Table 5 presents the results from regressing accounts receivable (scaled by assets) on the different explanatory variables.

4 Model I in table 5 is estimated using the variables listed in table 4 above. Since it seems possible that the relationship of accounts receivable with sales growth and cash flow is not linear, we estimate model II. The sales growth and cash flow variable are now both separated into two variables by multiplying them with (0,1) dummies indicating whether a particular observation has been positive or negative.

Demand for trade credit. It is convenient to think that the level of a firm’s accounts receivable depends on how much it decides to lend to its customers.

However, as Petersen and Rajan (1997) point out, there is most probably also a demand factor that affects the amount of The number of observations varies


Service Management System slightly across the different regressions because of listwise deletion of observations with missing data on some variable(s).As it is the common practice in related literature, assets is used as the scaling variable for both the dependent variable and independent variables when scaling is needed.

Potential problems related to this practice are dis-cussed in Kasanen and Lukka

(1993).

TABLE 5. The determinants of accounts receivable.

Dependent variable: accounts receivable/assets

Variable

Model I (N = 896)

Coefficient Significance level

LN(book value of assets) . 002

LN(1 + firm age)

% sales growth

% sales growth if positive, 0

% sales growth if negative, 0

–. 002

–. 0002

–. 046 Operating cash flow

Cash flow when positive, 0

Cash flow when negative, 0

Contribution margin . 091

Market interest rate

Year - dummy 1989


1 . 198

–. 094

–. 120

. 094

. 493

. 566

. 227

. 000

. 080

. 141

. 101

Model II (N = 894)


. 002

–. 002

. 289

. 279

–. 008

. 078

. 078

. 001

–. 082

–. 007

. 087

. 067

. 992

. 000

1 . 111

–. 088

–. 113

. 099

. 159

. 119



Year - dummy 1991 –. 122

Year - dummy 1992 –. 126

Year - dummy 1993 –. 059

Year - dummy 1994 –. 025


–. 031

Year - dummy 1996 –. 009

Manufacturing and mining . 049

Wholesale and retail trade . 041

Other services –. 015

Constant . 009

Adjusted R - squared . 238

. 000

. 000

. 133

. 790

. 000

. 069

. 066

. 059

. 138

. 106

. 356

. 049

. 042

–. 012

. 035

. 248

–. 111

–. 118

–. 054

–. 022

–. 029

–. 008

. 000

. 000

. 203

. 298

. 000

. 096

. 081

. 080

. 189

. 123

. 371 trade credit a firm is able to extend. This demand is practically impossible to measure directly. Most firms have many customers whose individual attitudes towards trade credit differ from each other. For instance, a retail firm may have thousands of credit customers who may be either individuals or other firms. On the contrary, the accounts payable of a given firm may be more homogenous since they usually are payables to other firms whose number at least in certain industries may be relatively small.

Since we don’t know the demand curve for trade credit, this issue must be taken into account when interpreting the estimated coefficients. Petersen and Rajan (1997) illustrate the alternative interpretations of the result that large firms have higher accounts receivable. First, this result may mean that larger firms are less capital constrained because they have better access to capital markets. An alternative interpretation is that a part of large firms’ customers may be credit rationed for one reason or another, and the larger than average accounts receiv-able of large firms may be explained by the demand factor. However, we believe that the use of industry


Service Management System dummies in our regression partly mitigates this problem since they divide the customers of the sample firms into more homogenous groups.

Creditworthiness and access to capital markets. A firm’s creditworthiness and access to capital markets are most commonly measured by firm size and age. We use the natural log of the firm’s total assets (Ln (Assets)) and the natural log of firm age

(Ln(1 + Firm Age)) to proxy for the supplier’s access to external capital.

5

The results in table 5 show that asset size is significant in model I (p = 0.094), but insignificant in model II. Firm age remains insignificant in both models, even when the square of the log of firm age is added in the model (the coefficient of the squared age variable is not reported in table 5). We added the squared age variable, because

Petersen and Rajan’s (1997) results show that after 19 years of operation a firm’s level of accounts receivable peaks and starts to decrease.

T he result that a firm’s creditworthiness and access to capital markets does not affect the level of trade credit it extends is theoretically unexpected, and it also differs from previous empirical findings by Petersen and Rajan (1997). Table 4 shows that firm size and age are correlated by factor 0.4. Although the correlation is not very large, it may be one reason be-hind the insignificance of firm size and age as predictors for trade credit extended.

Growth. Firms may have trade credit policies that are in connection with their target growth rates. Traditionally, credit terms such as trade credit discounts and time of payment are believed to be used as competitive tools. A firm willing to grow may choose a strategy of extending trade credit with longer due periods than its competitors. This suggests that growth should be positively related to the level of accounts receivable.

However, also firms whose sales have developed inadequately, may use trade credit to enhance their sales. Especially, a firm whose sales are declining may extend more trade credit than the average firm in its industry (Petersen and Rajan, 1997). In this study, we measure growth by the annual sales growth percentage.



Empirically, it appears that neither of the above theories holds. When negative and positive observations are in the same variable, the regression coefficient is insignificant.

However, when the variable is partitioned on the basis of the signs of the observations, it appears that the coefficient of the variable with negative sales growth numbers has a significant positive coefficient. When interpreted, this result means that the more negative a firm’s sales growth, the less trade credit it extends. On the other hand, the coefficient of the variable including positive growth observations is significantly negative

(p = 0.078), indicating that firms with high growth rates extend less trade credit than lowergrowth firms. The results are exactly the mirror image to Petersen and Rajan’s

(1997) results, who found that firms with high growth rates extend more credit than firms with lower growth rates. Additionally, their results showed that the more a firm’s sales declined the more it used trade credit to finance its customers’ purchases, and thus support both the above mentioned theories.

Internal financing. We use operating cash flow (earnings before depreciation and interest minus taxes) divided by assets to measure the firm’s ability to generate cash from internal sources to finance the trade credit that it offers to its customers. The results in Table 5 are mixed and difficult to interpret. When the initial cash flow variable is used, the coefficient is insignificant. However, when positive and negative observations are separated into two variables, the variable with positive observations has a negative coefficient (significant at the 6.7% level), while the variable with negative observations is insignificant. This result means that the larger positive cash flow the supplier has, the less trade credit it is willing to extend to its customers. Petersen and

Rajan (1997) find that the firm’s ability to generate cash internally from operations is statistically significant but its sign is unexpectedly negative. However, when they elaborate their analysis, they find that only losses are significantly negatively correlated with accounts receivable, and conclude that firms in trouble extend more credit to maintain sales. Our results may be considered exactly the opposite to theirs.



Price discrimination. Price discrimination is a practice whereby different buyers are charged different prices for the same product for reasons other than any differences which exist in the costs of supplying them. Monopolists will often enjoy the power to discriminate in this way. Our measure for price discrimination is the monopoly power of the firm measured by the ratio of contribution margin (sales minus variable costs) to assets. (See, e.g., Ferguson et al., 1993, for formal derivation and discussion).

In our sample of large Finnish firms, it appears that price discrimination is by far the most important variable explaining accounts receivable management policies. Its coefficient is positive and statistically very significant in both models I and II in table 5.

Cost of alternative capital . We use the annual average three-month HELIBOR rate to measure the underlying cost of capital. We expect to find a positive association between accounts receivable and the interest rate level, because the demand for trade credit can be expected to be highest when the cost of alternative sources of funds is high. Table 5 shows that the interest rate has a significant positive coefficient in both models I and II (p = 0.099).

Time . Our model includes eight year-dummies to control for annual changes with 1997 serving as the control year. All coefficients of the year-dummies are negative indicating that the level of trade credit was highest in 1997.

Interestingly, the negative coefficients are statistically significant during the period 1991

–1993, when the economic conditions in Finland were weak. Thus, it seems that the deep economic recession reduced the amount of trade credit extended.

Industry . The coefficients of the industry dummies for manufacturing and mining firms and for retail and wholesale firms are both positive and very significant. This indicates that firms in these industries extend more trade credit than in the two other industries (electricity supply and construction; other services).



4.2. Accounts payable

Table 6 presents the results from regressing accounts payable on their suggested determinants. The variables (including control variables) are for the most part the same as above in the model estimated for accounts receivable.

Additionally, there are two new variables: purchases (scaled by assets) describing the supply of trade credit and the ratio of current assets (financial assets and inventories) to total assets measuring asset maturity.

Model III in table 6 is estimated using the ’original’ explanatory variables, whereas in model IV the sales growth and cash flow variables are both separated into two variables one containing positive observations and the other negative observations.

Supply of trade credit. Petersen and Rajan (1997) use the fraction of the firm’s annual purchases made on account as a proxy for the quantity of trade credit offered to the firm. Their sample consists of small firms some of which may be credit rationed by suppliers. Since our sample firms are larger firms we make an assumption that all purchases are on credit and use their annual purchases as a proxy for the supply of trade credit. We believe that this assumption is not very restrictive, since large firms typically don’t pay their purchases in cash. In measuring the supply of trade credit we have an advantage over previous research since we know the exact amounts of the sample firms’ annual purchases. Petersen and Rajan had to estimate the amount of purchases to measure supply of trade credit since U.S. firms do not provide information on the division of cost of goods sold into different cost categories such as wages and purchases.

Because we use a proxy for the supply of trade credit, we can be more confident in interpreting the coefficients of the other variables in the model. The regressions for accounts receivable and accounts payable differ in this respect,


Service Management System since the coefficients of the former regression are reduced form coefficients that include both demand and supply side. (Petersen and Rajan, 1997).

The result concerning the supply of trade credit is clear and expected: purchases are statistically significantly associated with accounts payable, and their coefficient is positive. That is, an increase in the supply of trade credit enhances the level of its use.

TABLE 6. The determinants of accounts payable.

Dependent variable: accounts payable/assets

Variable

Model III (N = 911)


Purchases

LN(book value of assets)

LN(1 + firm age)

% sales growth

% sales growth if positive, 0

% sales growth if negative, 0

Operating cash flow

Cash flow when positive, 0

Cash flow when negative, 0

. 018

. 005

–. 001

–. 0006

. 085

Current assets % total assets

Market interest rate



. 041

. 825

–. 076

–. 091

. 000

. 037

. 040

. 020

. 000

. 000

. 402

. 006

. 000

Model IV (N = 909)


. 019

. 004

. 000

. 000

–. 002 . 134

–. 012

. 082

. 000

. 000

. 083

–. 128

. 001

. 062

. 043

. 795

. 000

. 037

–. 074

–. 085

. 039

. 038



Year - dummy 1991 –. 091

Year - dummy 1992 –. 088

Year - dummy 1993 –. 044

Year - dummy 1994 –. 019


–. 027

Year - dummy 1996 –. 007

Manufacturing and mining . 023

Wholesale and retail trade . 047

Other services

Constant

Adjusted R - squared

. 004

–. 062

. 241

. 000

. 000

. 528

. 001

. 000

. 020

. 027

. 016

. 049

. 014

. 163

. 023

. 049

. 006

–. 053

. 281

–. 082

–. 085

–. 041

–. 016

–. 026

–. 007

. 000

. 000

. 299

. 005

. 000

. 029

. 026

. 019

. 083

. 014

. 194

Creditworthiness and access to capital markets. The results in table 6 show that asset size is a very significant explanatory variable for accounts payable in both models

III and IV. How-ever, firm age remains insignificant in both models, even when the square of age is added in the model (coefficient not reported). We add the squared age variable, because previous re-search provides evidence that older firms have less investment opportunities than younger firms, and therefore they need less external funding.

The results concerning size and age contradict the notion that larger and older firms would use less trade credit than smaller and younger firms. The positive sign of the size variable indicates that large firms which even otherwise have easier access to the capital market use more trade credit in their financing. Also

Petersen and Rajan (1997) find that there is a weak positive correlation between the level of accounts payable and firm size.

Growth. Theoretically, it may be argued that rapidly growing firms have better investment opportunities than other firms and would thus be willing to use more trade credit as a partial source of financing for new investments. However, the empirical results show just the opposite. As a whole, sales growth is negatively associated with accounts payable (model III). When this variable is


Service Management System separated into two variables one containing the positive values (negative values are set to be zeros) and another containing the negative observations (positive values set to be zeros), both variables are very significant. On one hand, the coefficient of positive growth is negative indicating that the faster a firm is growing the less it uses trade credit in its financing. On the other hand, the larger the sales decrease, the less trade credit a firm will use. Therefore, the maximum amount of trade credit is used by firms who grow slowly or not at all.

Consistently with the theory explained above, Petersen and Rajan (1997) observe the mirror image of our results while they find that the more a firm’s sales is growing or decreasing the more it uses trade credit. One explanation to the different results is that Finland is traditionally a bank-dominated environment, and firms may rather turn to financial intermediaries (banks) than to extend the use of trade credit when their level of growth deviates from normal growth in one direction or another.

Internal financing. The results show that operating cash flow is a significant explanatory variable for accounts payable with an initially positive coefficient

(model III). However, when it is separated into two variables (model IV), it appears that the coefficient of positive cash flows is positive and the coefficient of negative cash flows is negative. This result means that the most liquid firms use more trade credit than the average firm and the same holds for firms with negative internal financing. The latter part of this result is consistent with the notion that firms in trouble use more trade credit, and it is also in line with

Petersen and Rajan’s (1997) results.

Asset maturity. The proportional share of current assets (current assets/total assets) is a (very) significant explanatory variable for the level of accounts payable. This is in line with the theories stating that firms attempt to finance assets of certain maturity with funds having the same maturity. This is done to schedule repayments of the financial capital to correspond with the decline in value in the firm’s assets (Myers, 1977; Diamond, 1991; Hart and Moore, 1991).



Therefore, short-term (current) assets are financed using short-term debt such as accounts pay-able, while long-term assets are financed using long-term debt or equity.

Cost of alternative capital. Market interest rate is a significant explanatory variable for accounts payable. It may be noted that it is statistically more significant than in the model(s) estimated for accounts receivable. This result may support the notion that movements of the market rate affect in particular the demand side of trade credit.

Time. The results concerning the year-dummies indicate that the level of accounts payable was highest during the control year 1997. All dummies except that of the year

1996 have statistically significant negative coefficients.

Industry. Industry effects are similar to the regressions for accounts receivable. The coefficients of the manufacturing and mining industries and the retail and wholesale industries are both positive and very significant indicating that firms in these industries use more trade credit in their financing than in the two other industry groups.

5 . C O N C L U S I O N

This study empirically examined the determinants of Finnish listed firms’ accounts receivable and accounts payable management policies. The results show that accounts receivable are strongly affected by the firms’ incentive to use trade credit as a means of price discrimination. Market cost of capital also has an effect on their level. The latter result may be largely explained by increasing demand of trade credit when market interest rates rise.

All the variables that were used to explain the level of accounts payable were statistically significant although their signs were not always expected. The results show that the most important variables behind accounts payable policies are supply of trade credit, firm size, level of interest rates, asset maturity, and internal (insufficient) financing.



The results of this study differ in many aspects from previous results obtained using

U.S. data. These differences may largely be due to differences between the Finnish and

U.S. capital markets, since Finland has a bank-based system much like those of

Germany and Japan. Corporate bond markets are basically non existent, and banks form the major source of capital even for most large firms. One obvious line of further research would be to examine the role of bank-borrower relationships, as financial intermediaries are an alternative source of capital for trade credit. However, data on relationships between firms and banks is private, and data samples containing such information are not publicly available

R E F E R E N C E S

BIAIS, B. and C. GOLLIER, 1997, Trade credit and credit rationing, Review of Financial

Studies 10, 903 – 937.

BOOT, A. and A. THAKOR, 1999, Can relationship banking survive competition?

Working paper, University of Amsterdam.

BRENNAN M., V. MAKSIMOVIC, and J. ZECHNER, 1988, Vendor financing, Journal of

Finance 43, 1127

– 1141.

DIAMOND, D., 1991, Monitoring and reputation: The choice between bank loans and directly placed debt, Journal of Political Economy 99, 689 –721.

FERGUSON, P.R., G.J. FERGUSON and R. ROTSCHILD, 1993, Business Economics

(Macmillan).

FERRIS, J. S., 1981, A transactions theory of trade credit use, Quarterly

Journal of Economics 94, 243 – 270.

FRANK, M. and V. MAKSIMOVIC, 1998, Trade credit, collateral and adverse selection, Working paper, University of Maryland.



HARHOFF, D. and T. KÖRTING, 1998, Lending relationships in Germany – empirical evidence from survey data, Journal of Banking and Finance 22,

1317 –1353.

HART, O. and J. MOORE, 1991, A theory of debt based on the inalienability of human capital, Working paper, MIT.

KASANEN E. and K. LUKKA, 1993, Yleistettävyyden ongelma liiketaloustieteessä, Liiketaloudellinen Aikakauskirja 41, 348 –379.

KASHYAP A.K., J.C. STEIN and D.W. WILCOX, 1993, Monetary policy and credit conditions: evidence from the composition of external finance,

American Economic Review 83, 78 –98.

La PORTA, R., LOPEZ-DE-SILANES, F., SHLEIFER, A., and R. VISHNY,

1997, Legal determinants of external finance, Journal of Finance 52, 1131

–

1150.

LEE Y.W. and S.D. STOWE, 1993, Product risk, asymmetric information and trade credit, Journal of Financial and Quantitative Analysis 28, 285 –300.

MAROTTA, G., 1998, Does Trade Credit Redistribution Thwart Monetary

Policy? Evidence From Italy, Working paper, University of Modena.

MYERS, S.C., 1977, Determinants of Corporate Borrowing, Journal of Financial

Economics 5, 147 –175.

MIAN, S. and C. SMITH, 1992, Accounts receivable management policy:

Theory and evidence, Journal of Finance 47, 169 –200.



PETERSEN, M. and R. RAJAN, 1994, The benefits of lending relationships:

Evidence from small business data, Journal of Finance 49, 3 –37.

PETERSEN, M. and R. RAJAN, 1995, The effect of credit market competition on lending relationships, Quarterly Journal of Economics, 407 –433.

PETERSEN, M. and R. RAJAN, 1997, Trade credit: Theories and Evidence,

Review of Financial Studies 10, 661 –691.

RAJAN, R. and ZINGALES, 1995, What do we know about capital structure?

Some evidence from international data, Journal of Finance 50, 1421 –1460.

SCHWARTZ, R.A., 1974, An economic model of trade credit, Journal of

Financial and Quantitative Analysis 9, 643 –657.

SMITH, J., 1987, Trade credit and information asymmetry, Journal of Finance 4, 863

–

869.

Author: J NISKANEN

Title: Accounts Receivable and Accounts Payable in Large Finnish Firms’ Balance

Sheets: What Determines Their Levels?

URL: http://www.htmlpublish.com/convert-pdf-to html/success.aspx?zip=DocStorage/da1132e3bdaf4baab53963a75cda2442/lta_2000_0

4_a2.zip&app=pdf2word#

Management of Accounts Receivable

December 1997



----------------------------------------------------------------------------------------------------------

Contents

Preface

Introduction

The Accounts Receivable Process

Re-Engineering Accounts Receivable

Risk Management

Use of Advanced Technology

Debt Collection Processes

Performance Measurement

Appendix

Preface

This guide accompanies the Auditor-

General’s Audit Report No. 29,

Management of

Accounts Receivable in the Commonwealth. It is intended to provide an overview of the


Service Management System current trends and "better practice" approaches that are being adopted by organisations in managing accounts receivable.

In the commercial world the way in which organisations manage their accounts receivable has significant implications for the financial health of those organisations.

This creates an imperative to ensure the management of receivables is both efficient and effective. The practices used in common business processes such as accounts receivable management have universal application and are not industry specific. In this regard there are lessons to be learned by others from the practices followed by organizations for whom accounts receivable is a core business process. The better practices discussed in this guide are therefore recommended for consideration by

Commonwealth government agencies.

Not all of the practices outlined in this guide will suit each agency’s circumstances, however, it is considered that most agencies, which derive revenue on sale of goods and services on credit terms, will benefit from benchmarking their current practices against those detailed in the guide.

Introduction

Effective management of accounts receivable presents important opportunities for agencies to achieve strategic advantage through improvements in customer service, cash management and reductions in costs.

The primary objective of accounts receivable in the Commonwealth public sector is to collect monies due and to assist in meeting cash flow requirements. An effective accounts receivable function can assist in achieving the desired cash flow outcome through the timely collection of outstanding debts.

All agencies also have an objective of continually improving customer service. A large number of agencies which operate as businesses are required to perform public


Service Management System services under a full or partial cost recovery arrangement. Effective accounts receivable management can assist agencies improve customer service through providing timely information on customer requirements and by making dealing with the agency as easy as possible.

All government agencies, including those operating in a monopoly, are required to demonstrate contestability - that is delivery of a high quality standard of service at a cost that is comparable to providers of similar services operating in similar environments.

Improvements in accounts receivable management which reduce the cost of collecting monies can improve an agency’s ability to demonstrate contestability and accountability.

Importance of Organizational Culture

An international receivables management benchmarking study commissioned by the

Australian Taxation Office has highlighted the importance that organizational culture has in the successful management of accounts receivable. The study, which involved the survey of five international taxation agencies and eight domestic organizations for which accounts receivable is a strategic issue, indicated that management attitudes need to support practices for minimization of debt.

All agencies should adopt a culture whereby staff are encouraged to obtain payment, where required, and not just focus on program or service delivery.

The Accounts Receivable Process

A typical accounts receivable process is mapped below.

The process commences with a receipt of a customer order and ends with the collection or write off of a debt.

Financial management functions such as accounts receivable have been traditionally viewed as transaction processing activities. An international benchmarking study


Service Management System referred to in the Paying Accounts Better Practice Guide issued by the ANAO in

November 1996 indicated that up to 65 per cent of time was spent on non-value added activities across all government and industry sectors. The study suggested that the elimination or reduction of non-value tasks can be effected through better work practices and automation of processes. This can be achieved by analysing current processes and redesigning them to remove as much manual intervention as possible, reducing rekeying and appraisal activities and minimizing operator error. An important part of this analysis is a formal, structured risk assessment which identifies and measures exposures associated with the accounts receivable process.

The following diagram highlights the opportunities available for improvement through better practices.

Significant advances in accounts receivable performance and process efficiency are available to agencies through the following five complementary key management initiatives:

• Re-engineering accounts receivable

• Risk assessment

• Use of advanced technology

• Debt collection processes

• Performance Measurement

These matters are addressed in the following chapter.

Re-engineering accounts receivable



Some large private sector organizations have achieved real cost reductions and performance improvements by re-engineering the accounts receivable process. Reengineering is a fundamental rethink and re-design of business processes which incorporates modern business approaches.

The nature of accounts receivable is such that decisions made elsewhere in the organization are likely to effect the level of resources that are expended on the management of accounts receivable. An illustration of this point is the extra effort that must be put into debt collection where credit policy is poorly administered or too freely given. The strong linkages between different processes means that true improvements cannot be achieved without focusing on all aspects of the management of accounts receivable.

The following better practices present opportunities to improve the accounts receivable function.

Centralized Processing

A better practice for the delivery of finance services is the adoption of centralized processing for finance functions such as accounts payable and accounts receivable.

Centralized processing groups are typically high volume transaction processing centers servicing multiple operating groups. Their establishment achieves a number of benefits for the organization. These include the achievement of a high degree of specialist expertise in the function supported, the establishment of centers of excellence that develop and enforce common practices and standards and the achievement of cost efficiencies through the co-locating of systems and staff. The establishment of these centres also frees up other staff for more value adding work.

One private sector firm reduced its total finance staff numbers by 12 per cent through centralized processing.



Standing Payments

Research into better practice indicates that repayment rates are significantly enhanced by providing customers and debtors with alternative payment approaches. In addition to there being alternative payment methods there are also alternatives to issuing invoices in the traditional accounts receivable processing approach. These alternative payment strategies result in efficiencies in the management of accounts receivable.

An approach that is available to agencies which deliver services on a regular basis resulting in recurring invoicing and receipting cycles is to arrange for the provision by customers of standing payments. An annual or bi-annual settlement can be undertaken to reconcile payments to services provided. The process can be facilitated by providing customers with regular updates of fees charged.

The benefits of this approach to the service providers is the reduction of costs through the removal of the need for an invoicing and debt collection function and the more timely receipt of revenues. There is also benefit to the customer through the streamlining of payment processes. The approach is most effective if adopted in conjunction with payment by direct debit of customer bank accounts.

Alternative payment options

Private sector organizations and public authorities are finding that payment of accounts outstanding is likely to be quicker where a number of payment alternatives are made available to customers. They also find that the availability of convenient payment methods is a marketing tool that is of benefit in attracting and retaining customers.

The following modern payment methods are available and provide the benefits of added customer service, reducing remittance processing costs and improving cash flow through faster debtor turnover.



Direct debit - involves authorization for the transfer of funds from the purchaser’s bank account; this approach has the advantage of reduced processing costs, however it can present security exposures.

Integrated Voice Response - a system which combines use of human operators and a computer based system to allow customers to make payments over the phone, generally by credit card; this system has been proved highly successful in organizations which process a large number of payments regularly.

Outsourced Agency Collection - payments are collected by an external agency under a contractual arrangement (e.g. Australia Post). The payment method under this approach can be either cash, check, credit card or EFTPOS. This method increases flexibility and convenience to the customer which may lead to improvements in the rate of payment. A variant on this approach is BPAY , a system whereby banks act as outsourcing partners by collecting payments from suppliers’ customers and directly crediting supplier accounts.

Lock Box processing - an outsourced partner captures check and invoice data and transmits the file to the client agency for processing in that agency’s systems. This approach transfers the cost of data collection to service provider.

Other payment methods such as use of data kiosks by customers in public use areas and payment for goods and services via the Internet are likely to become readily available in the near future.

Each of the above payment types have advantages and disadvantages which are likely to be peculiar to the environment that particular agencies operate in. Agencies need to balance the benefits in both the payment and receipting processes against the costs that some payment options may present to the agencies themselves.



Marketing and educational activities can be used to promote timely payment.

Agencies should provide information on the nature of products or services available, the required payment cycle, payment options available and the consequences of non payment.

Customers should be aware of their liability at all times. A practical way of achieving this objective is the issue of monthly customer statements.

Use of Payment Incentives

Private sector practice has been to, over time, reduce the level of reliance on discounting as an incentive for prompt payment. However, the practice is still used in government instrumentalities in Australia and should be considered by agencies which have problems with debtor turnover. Discounting can be used as an incentive for customers to pay upon receipt of services, thereby avoiding the use of credit terms.

Whilst discounting has the advantage of potentially shortening the average collection period it also reduces net revenue. Before deciding to offer discounts agencies should conduct an analysis of the effect that the utilisation of discounting will have on net revenue. This estimate should be balanced against the costs of continuing to hold receivables at their existing levels, which is effectively the market interest rate applied to the annual carrying cost of receivables. Another issue for consideration is the alternative uses to which the funds tied up in receivables could be put.

In addition to developing a range of incentives for early payment agencies should consider the imposition of penalties on late payment. In designing penalties agencies should be aware of legislative and policy considerations which may reduce the potential for major penalties such as removal of service.

Case management approach



Where individual customers have strategic importance to the agency a case management approach may be adopted to the management of the agency-customer relationship. Under this approach all aspects of the relationship are drawn together including debt management. The increased knowledge of the customer that derives from the adoption of a case management approach can assist in the design of strategies for the prompt repayment of debt.

Risk assessment

Risk assessment is a major component in the establishment of an effective control structure. Once risks have been properly identified, controls can be introduced to either reduce risks to an acceptable level or to eliminate them entirely. A proper risk assessment also creates opportunities for freeing processes from inefficient practices.

In managing accounts receivable the key areas that management should focus on for the purpose of conducting a risk assessment are:

• debt management processes, and

• outstanding debts and debtors.

Debt management processes

The risk analysis involves a re-think of processes and questioning the way that tasks are performed. A risk assessment opens the way for efficiency and effectiveness benefits in the management of accounts receivable. In particular, processes can be redesigned to achieve the following benefits:

• the establishment of clear and concise policies for issuing credit and for recovery of debt;

• the removal of non value adding tasks and clarification of roles and responsibilities, by, for example, streamlining delegations;

• the establishment of controls where exposures are noted;

• allowing staff to apply more initiative and ingenuity to every day tasks and;



• the identification of new and more effective ways of delivering services.

A credit policy document is a key component of the accounts receivable control environment and needs to cover all aspects of revenue and debt collection practices. It needs to be:

• written in plain English so that it is understandable by staff and customers;

• accessible to all staff who are required to administer it; and

• made available to customers in summary form. In addition, it should

• establish a financial threshold under which it is uneconomical to pursue recovery action;

• set down criteria against which a debt might be considered for waiver;

• be kept up to date. This means it should be reviewed at regular intervals so that consideration can be given to incorporating new practices or initiatives, and

• be endorsed by executive management

Agencies should be aware that the credit term set in a credit policy will have a direct impact on their terms of trade.

A checklist of features which should exist within a good policy document is included as an appendix to this Guide.

Outstanding debts and debtors

The application of a credit policy will not be fully effective unless there has been a comprehensive risk analysis of the customer population performed. This can be achieved by having detailed information on the characteristics of customers (and potential customers) and through the establishment of criteria against which to assess the credit worthiness of individual customers.



The criteria needs to be laid out in the credit policy. Sufficient information on customers will need to be held on a comprehensive customer database. Key components of the database are:

• billing name and address;

• credit information;

• place of purchase;

• date of purchase;

• special service requirements (will vary with the nature of the service);

• method of payment;

• payment history; and

• customer type.

This database will need to be regularly maintained and updated.

Use of Advanced Technology

Advances in technology present an opportunity for improvement in accounts receivable processes. The principal innovations available are the integration of systems used in the management of accounts receivable, the automation of debt collection processes and the use of electronic commerce.

Systems Integration

Improvements are available from the integration of the revenue and accounts receivable systems. This integration results in remittances being automatically credited against a customer account with a simultaneous update of the general ledger. This process avoids the downloading of data and re keying.

A fully integrated system could exhibit some or all of the following features:

• electronic invoice; which extracts details from database of approved customers, credit terms and which is authorised electronically;



• quantity, price and account code for sales entered once only, on invoice;

• electronic notification of delivery of goods/services;

• customer and account code details extracted automatically from customer order for payment;

• automation of reminder letters, and

• automatic triggering of write-off or waiver action.

Electronic Commerce

Electronic commerce is a term applied to the use of computer and telecommunications technologies, particularly on an inter organisational basis, to support trading in goods and services. It uses technologies such as electronic data interchange (EDI), electronic mail, electronic funds transfer

(EFT) and electronic catalogue systems to allow the buyer and supplier to transact business by exchanging information between computer applications systems. This achieves cost savings by removing the need for direct negotiation between the parties.

The Commonwealth government has required departments, through its

Commonwealth Electronic Commerce Service , to ensure that all suppliers and potential suppliers of goods and services are given the opportunity to transact their business electronically. In its Statement of Direction on electronic commerce issued in July 1996 the government noted:

"There is, in addition, an unrealized potential for the wider application of other electronic commerce technologies."

The Statement indicated that individual departments should:

"take account of the opportunities offered by electronic commerce in their business planning processes, and include in their information technology and telecommunications


Service Management System strategic plans relevant provisions covering the use or intended use of electronic data interchange both for core functions and in support applications."

The objective of the Commonwealth Electronic Commerce Service to date has been to promote the use of electronic commerce by government agencies in purchasing. It is proposed to extend the system to payment of accounts in the near future. In situations where the government service recipients are other government agencies or non government organizations which operate IT systems which have electronic commerce capabilities the potential exists for use of electronic commerce in accounts receivable.

This potential is likely to increase in the future.

Debt Collection processes

Debt collection processes should be undertaken with the objective of reducing outstanding accounts while keeping sight of the need to maintain customer goodwill, in an environment of cost restraint.

Better practice in debt collection includes the following:

• assessment of debts against a financial threshold before proceeding with recovery action;

• review of the accuracy of invoices following failure by debtors to respond to a letter of demand;

• categorize debtors in accordance with their ability and willingness to pay.

• Tailor debt collection processes in accordance with results of this analysis;

• prioritize debt on the basis of risk indicators. The indicators could include the payment history of the customer, debt level, demographics, etc;

• communicate directly with debtors most probably by phone and obtain personal commitment as to repayment schedule;

• staff have the authority to negotiate payment options within guidelines, without further approval from management;



• treat debt collection as a specialist function. Recruit specialists as required and provide appropriate training; and

• consider outsourcing all or part of the debt collection process to a private collection agency. Where debt collection is outsourced agencies should ensure that the Information Privacy Principles as laid down in the Privacy Act

1988 are complied with.

Of vital importance in the design of debt collection procedures is the need to be proactive about the recovery process. Credit industry advice is that the more a debt ages, the greater is the risk of non recovery. Estimates are that allowing a debt to age more than 90 days increases the risk of non recovery by at least 20 per cent.

Performance Measurement

An integral part of the re-engineering of any finance function is to develop a suite of indicators which will measure progress over time.

The following tables may be used by agencies both to establish performance indicators and to measure improvements which result from re-engineering the accounts receivable process. Each list should be modelled and adapted as necessary to suit the requirements of individual agencies.

Table 1 is an example of a type of value analysis. Under this approach the data on time spent on each part of the process would most likely be based on estimates. The benefit of this approach is that it makes clear to managers the proportion of time that is spent on non value adding activities in the accounts receivable cycle. This type of analysis is not an absolute indicator of cost effectiveness of processing as it takes no account of costs, however, it does demonstrate the interrelationship between the various steps in the process and therefore opportunities to reduce non value added activities.



Table 2 provides examples of the types of performance indicators that agencies can use to measure themselves against both standard and best practice, at a point in time and over time.

Following is an outline of the possible uses of some of the measures of effectiveness in accounts receivable management:

Debtors turnover - This ratio measures the average period for which sales revenue will be held in accounts receivable. This measures the efficiency and effectiveness of receivables collection.

Accounts Receivable to Revenue ratio - This ratio can be used to highlight trends in the level of investment in accounts receivable. Where accounts receivable as a proportion of monthly revenue exceeds an established bench mark, thereby indicating the possibility of interest foregone, the matter can be highlighted for management attention.

Receivables Aging Schedule - This schedule is a listing of debtors by aging category.

Analysing this schedule allows Accounts Receivable management to spot problems in accounts receivable early enough to protect the agency from major revenue problems.

It may also assist in highlighting individual delinquent accounts.

In addition to measuring the effectiveness of the accounts receivable process as a whole specific debt collection techniques and their effectiveness should be monitored.

This information can be used when assessing alternative debt collection strategies. It is of assistance when conducting assessments of this type to be cognisant of the costs of the relative collection strategies.

An important consideration in this process is the cost of measuring and analysing performance data. Where possible agencies should seek to have performance


Service Management System information on activities such as accounts receivable part of their Financial

Management Information Systems. The current move of

Commonwealth agencies from cash based accounting systems to accrual systems presents an opportunity for agencies to include the production of performance information as a feature of any new systems.

It is also critical that reports be timely, present information in a readily digestible fashion and that they are directed to the appropriate levels of management. Reports presented to higher levels of management are more effective when they are presented in summary form, often with table or chart form presentations. Reports containing too much data are unlikely to be effective. Better practice would be to obtain management input into the design of reports to ensure that the reports are used as intended. A good starting point in designing management reports is to carry out a survey of users to establish what they like and dislike about the current suite of reports.

Table 1 - Example of Value Analysis of Accounts Receivable Activities

Activity Value Current Current Target

Hours

% Time Hours

Time

Set price VA

Grant credit BR

Make sale VA

Issue Invoice BR

Update receivables ledger BR



Deal with customer inquiry NVA

Receipt payment VA

Issue monthly statement NVA

Issue letter of demand NVA

Determine repayment schedule with NVA debtor

Match payment to invoice BR

Code: VA - value adding; NVA - non value adding; BR - business requirement

Table 2 - Suggested performance indicators

Indicator

Invoices

Efficiency Measures processed per

Time Equivalent

Remittances processed

FTE per month member per month

(FTE)

Full staff per

Current Target Common Best

Benchmark Practice

Bench mark

1000 5000

2000 8000



Debtors contacted per FTE per month

Direct labour cost per invoice/remittance/debt collection action

Cost of accounts receivable as a percentage of revenue from credit sales

Cost of accounts receivable as a proportion of total administrative costs

Effectiveness Measures

Accounts Receivable as a percentage of total revenue

Debtors turnover i.e average time to collect

Debt written off as a percentage of total debt

Doubtful debts as a percentage of total debt

Percentage of debts collected within terms of trade

Debtors by age group as a percentage of total debt

-aged 30 to 60 days

-aged 60 to 90 days -aged > 90 days

Accounts Payable and Receivable with Treasury (APART MS)

0.3%

*

0.15%

Page 87


50%

30%

20%

15%

Proportion of debts settled by electronic means, i.e EFT

#

30 days f

10%

23 days

1%

90%

15%

10%

5 %

10% 100% costs will vary with the nature of invoice production and issue, the nature of remittance and the type of debt collection action dependent on nature of business


Service Management System a relatively low figure will indicate better practice, however, the level of doubtful debts will be influenced by factors outside accounts receivable management such as accounting policy

Appendix

The following is a checklist of features which should exist within a good policy or

procedure document.

The policy is endorsed by an Executive Officer

The policy is based on a risk assessment of the agency and it’s customers. This is recognized in the document by stating the risk factors.

The policy:

• Explains the nature of debts and debtors

• Outlines the agency’s rights and duties with debtors; and legal consequences.

• Details the terms of trade and circumstances when a delegate may change the terms of trade

• Identifies other related procedure manuals, legislation which can guide processing of debts.

• Outlines mode of payment accepted and under what conditions (eg any transaction less than $1,000 must be by credit card)

• Identifies mechanisms for reviewing requests from debtors

• Outlines general procedures for handling unusual requests or events

• Outlines who is responsible for debt collection



• States how and when to communicate with a debtor regarding an overdue amount

• States procedures to recover debts from employees

• Lists options for recovering an overdue debt (eg allow instalments)

• Describes the use of commercial debt collection agencies

• Identifies whom has the authority for determining the mode of collecting an overdue debt (eg instalments) and identifies circumstances to guide the decision.

• Identifies when to record a debt as overdue (including whether a period of grace applies).

• Details procedures for imposing charges

• Details the preparation of and requirement for certain report production

• Identifies means of monitoring debts

• Outlines the process of managing dishonored checks

• Lists circumstance when debts no longer need to be pursued and whom has the authority to decide not to pursue a debt

• States clear and comprehensive standards of performance (including the desired relationship with the customer) and targets for the timing of debt collection (eg 80% within 30 days from date of invoice).

• Details the requirement to review the policy and procedures - when, whom by

Author:

Title: Management of Accounts Receivable

URL: www.ahao.gov.au/uploads/.../Management of Accounts Receivable.pdf

Date Published: December 1997



ANALYSIS/SYNTHESIS:

We notice the complexicity of the AR and AP in different firms, from household AP/AR to a commercial and business organizations. They have different Payables components.

Same is true in what they receive. But one thing in common that matters most is the generation of a specifically detailed report that an accountant can rely on. Though it differs from time-to-time updates (weekly, monthly, quarterly, annually, etc.), they still spread out the clear details of where the company's budget is allocated. They also have a good communication along with the governing bodies of law that constitutes their economical process. Of course, each company mentioned above has a unique set of computations of their accounting process. We observed how relevant the AR/AP process in accounting. It serves as a "balancer" in accounting core group. But due to economic differences, some AP/AR structural figures are differently defined along with other accounting subsystems.



BESTLINK COLLEGE OF THE PHILIPPINES

College of Information Technology

#1044 Brgy Sta. Monica, Quirino Hi-way Novaliches, Quezon City

Questionnaires :

1.

Can we have the origins of the previous system being used?

2.

What is the difference between AR and AP? (Accounts

Payable/Receivables) in your system?

3.

What particular accounts do you handled difficult?

4.

Can we know how you compute the AP/AR in your existing system?

5.

What specific reports do you issue?

6.

Who is/are the personnel using the system?

7.

In your case, as a Security Agency, what particular payables and receivables do you have?



8.

Do you use Purchase Order? How?

9.

Do you use Receiving Reports? How it goes along with the system?

10.

How about the Vendors invoice.

11.

Can we have a sample of your forms/reports?

12.

How do you update your account payables and receivables? Is it weekly, monthly, quarterly, etc?

13.

Do you encountered problems while using the system?

14.

Can we know the System’s scope?

15.

When using the system, do you have in mind that you must have an assistant? Why or why not?

16.

How the Manager/Head monitors the transaction process?



17.

What database management you use?

18.

How can you describe its connection with your treasury system? Can we view them?

19.

Just in case, what particular perspective do you want to your existing system to change?

20.

Is this system can be operated only by accountants, or it is an easy-to-use to other assigned personnel?


Service Management System - bestlink college of the philippines

Factoring of Receivables

Accounts Receivable and

Accounts Payable in Large Finnish

Firms’ Balance Sheets: What

Determines Their Levels?

ABSTRACT

Management of Accounts Receivable

December 1997

Contents

Preface

College of Information Technology

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Service Management System - bestlink college of the philippines

Factoring of Receivables

Accounts Receivable and

Accounts Payable in Large Finnish

Firms’ Balance Sheets: What

Determines Their Levels?

ABSTRACT

Management of Accounts Receivable

December 1997

Contents

Preface

College of Information Technology

Related documents

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