What Are Collections in Accounting & Why They Matter

Collections in accounting refer to the systematic process businesses undertake to recover outstanding payments from customers who have purchased goods or services on credit. This process is fundamental to a company’s financial health. Effective collections ensure that the revenue generated from sales is converted into usable cash.

What Collections Mean in Accounting

Collections involve the pursuit and recovery of payments for goods or services that have already been delivered but not yet compensated. The primary source of these items is “accounts receivable” (AR), which represents money owed to a company for sales made on credit, essentially a short-term loan extended to customers.

Businesses extend credit to facilitate sales and attract customers, but this practice inherently introduces the risk of non-payment. This necessitates a structured collection effort to mitigate potential losses and ensure financial stability. Without effective collection procedures, a significant portion of earned revenue could remain tied up in unpaid invoices.

While the principle of collecting overdue payments remains consistent, the scale and approach can differ between business-to-business (B2B) and business-to-consumer (B2C) collections. B2B collections involve larger invoice amounts and ongoing relationships, whereas B2C collections deal with smaller individual debts and are subject to more stringent consumer protection laws. Regardless of the business model, robust collection practices are important for maintaining healthy cash flow.

The Collections Process

The collections process follows a chronological progression, beginning once an invoice becomes overdue. Initial efforts focus on internal communication and reconciliation to recover the outstanding balance.

Internal collection efforts start with sending reminder notices or “dunning letters” a few days to a week after the invoice due date. If payment is not received, follow-up phone calls are made within 15 to 30 days past due. These early communications aim to remind the customer of the overdue payment and address any issues or disputes.

Should internal efforts prove unsuccessful, accounts may be escalated within the company, perhaps to a senior collection specialist, after 60 to 90 days past due. At this stage, communication becomes more assertive, focusing on securing a payment commitment or establishing a payment plan. If internal measures are exhausted, the company may consider external collection avenues.

External collection involves engaging third-party collection agencies or pursuing legal action for overdue accounts after 90 to 120 days past due. For consumer debts, third-party agencies must adhere to federal regulations like the Fair Debt Collection Practices Act (FDCPA), which sets guidelines for communication and conduct. The goal is to recover funds efficiently while preserving customer relationships when feasible.

Key Financial Impacts of Collections

Successful collection activities have a positive influence on a company’s financial statements and overall financial health. The most immediate impact is on cash flow, as collected receivables convert into cash. This influx of cash is essential for funding daily operations, making timely payments to suppliers, investing in growth opportunities, and servicing debt obligations.

Uncollected debts lead to a “bad debt expense” on the income statement, which reduces a company’s net income. This expense recognizes that a portion of credit sales will never be collected. Businesses estimate this loss through an “Allowance for Doubtful Accounts,” a contra-asset account on the balance sheet that reduces accounts receivable.

On the balance sheet, collections reduce Accounts Receivable, converting a non-cash asset into cash, a highly liquid asset. This conversion improves the company’s liquidity. Efficient collections enhance working capital, the difference between current assets and current liabilities. Healthy working capital indicates a company’s ability to meet short-term obligations and invest in growth.

Measuring Collection Effectiveness

Accounting professionals use various metrics and tools to assess collection efficiency and success. These measures provide insights into a company’s ability to convert credit sales into cash.

One metric is Days Sales Outstanding (DSO), which calculates the average number of days it takes a company to collect revenue after a sale. A lower DSO indicates more efficient collection processes and quicker access to cash. DSO is calculated by dividing total accounts receivable by total credit sales for a period, then multiplying by the number of days in that period.

Another tool is the aging schedule, a report that categorizes accounts receivable by the length of time an invoice has been outstanding, typically in buckets like 0-30 days, 31-60 days, and 90+ days. This schedule helps identify overdue accounts and prioritize collection efforts based on the age of the debt, as older debts are harder to collect. These metrics enable management to identify trends, evaluate credit and collection policies, and make decisions to optimize cash flow.