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The Balance Sheet: a Great Hiding Place for Problems

by CRP Partner Gil Osnos

Most executives don’t usually think of the balance sheet as a place full of problems. But directors and audit committees often direct management and outside auditors to identify and review these types of hiding places. Understandably, some executives, especially in large organizations, may not be fully aware of these kinds of issues.

An analysis of accounts receivables can provide a wealth of information and insight about the organization, its effectiveness, its policies, and how customers view the company. In turn, this analysis can provide insight into areas for improvement. Receivable deductions are reflected on the income statements as returns, allowances, and discounts. What may not be apparent – because they have not yet been recognized – are unapplied credits. These items tend to distort the receivables balance and reflect future cash collections that may never materialize into cash. Many income statements begin with Net Revenue. Simply displaying Net Revenue masks the dilution from Gross Revenue.

An organized and systematic review of returns, discounts, and allowances indicate adjustments that reflect, in part, current policies and practices. Hidden from view are the unapplied credits to the receivables ledger. These unapplied credits and the aging report are great hiding places for problems. Problems are opportunities waiting to be exposed.

Reviewing Receivables

Receivable aging reports, unapplied credits, and unapplied cash should be reviewed at least once a month. An in-depth review of these aging items can indicate laxity in credit administration, quality problems, or failure of adherence to company policies. Unapplied credits distort the collectability of receivables. Unapplied cash impedes the ability of the collection department to pursue account debtors aggressively. It is embarrassing to call for a collection when the invoice has already been paid, but not applied to the receivables ledger.

Reasons for customer deductions can range from disputes over pricing, failure of posting the correct price on the order, unauthorized returns, unauthorized discounts, unauthorized advertising allowances, lack of adherence to the customer’s shipping instructions, late deliveries, partial shipments, and quality problems.

This treasure chest of information provides a great opportunity to gain insight into organizational performance.

Organize Company Dilution Data

First, the data must be organized into a meaningful report. This is accomplished by establishing a specific code for each type of deduction for each classification; in other words, reasons for returns, reasons for discounts, etc. A periodic ranking by dollar amount and frequency provides senior management with insight to prioritize problems and attack them in sequence. Priorities, thus established, can provide the greatest impact to bottom line performance and free up working capital.

In a company supplying turnkey solutions, an investigation of slow receivables indicated major problems in manufacturing. The balance sheet looked healthy and the income statement did not indicate any problems. The aged receivables indicated there was a problem, but where was it? Despite the balance sheet and income statement, the company was short of cash. Why?

The company had been shipping defective product in one product line to customers who refused to pay until the problems were corrected. This resulted in a complete review of manufacturing, product design and product development.

In another company, several companies had been acquired and rolled up in a very short period of time. The new owners were in a hurry to realize the ”economies of scale”. Management was inexperienced and reacted to the pressure without thinking through how to systematically combine and eliminate redundant functions. The idea was to centralize all receivable and collection management into one location. Outstanding invoices were packed up in boxes and sent to the new location. Each company had its own receivables software program. They were not compatible.

At the corporate level all receivables were combined, but there was no way to apply a collection to a specific account debtor’s invoice in many cases. All new receivables were recorded on about six of the old systems, and collections were monitored on them. There were stacks of old invoices, too many to track each collection from each account debtor. The amounts owed by each customer were known at the time of the acquisition, but the ledgers were not maintained. The collections department was gun shy about making calls, since some customers were customers no more, many customers had paid, and for those who did not, there was no back up information to prove that they had not paid.

Receivable aging at the corporate level kept growing and lenders, management, and the board did not understand why. The solution was:

Write new enterprise software program to consolidate the remaining systems into one.
Hire an outside collections firm to see if they could work down the pile of old receivables.
Ensure daily discipline in applying cash to the individual account debtor ledgers.
Research and book authorized unapplied credits to each account debtor ledger.

It is difficult to call a delinquent account without having its ledger up to date. It is even more difficult, to make that embarrassing when the cash was received but not applied. Even worse, when the account was past due and no longer included in collateral pool, the company’s borrowing capacity was reduced.

An aging review can save the day.

A few years ago a client was experiencing difficulty. Many of its customers had reached their credit limit and were not able to purchase any more goods and services. Collections were slow and the company sorely needed cash. The accounting department was organized into teams for a telethon. Each team was provided with a list of slow payers. The results were impressive. Cash receipts were accelerated and disputes were reconciled. The telethon also uncovered the fact that many accounts had the same address and phone number.

The credit department had allowed any new account up to $500 credit before performing an in-depth analysis. The sales representatives in one region had opened up new accounts for the same customer under different names, once those customers had reached their credit limits and could not buy any more.

Sales reps were paid on commission based on sales, and not on collections. Therefore, when an account hit its credit limit, they simply opened a new account for the customer under a different name. This way, the customer received additional goods and services and the sales representative received his commission. The district manager was aware of and condoned this practice. He also was evaluated on gross revenue and not on collections.

Without a thorough aging review and the telethon, the problem would not have been discovered. The day after our discovery there were some major personnel changes. In effect, the sales force was stealing form the company. There were also some changes in credit and collection management and policies. There is no profit until the cash is collected.

A periodic review of the ranking of deductions, ageing, and unapplied cash and credits enables top management, the audit committee, and the board to ask the right questions. The insights gained from these reviews maintain management focus on, receivables investment at the proper level, and improve organizational effectiveness.