What Is the Largest Risk of Selling on Account?

When businesses extend credit to customers, allowing them to pay for goods or services at a later date, they engage in a common commercial practice known as selling on account. This approach can facilitate increased sales volume and foster strong customer relationships by offering payment flexibility. However, extending credit inherently introduces financial considerations that require careful management to avoid potential disruptions to a business’s financial health.

Understanding Sales on Account

Selling on account means a business provides products or services to customers with an agreement for payment at a future date, typically within a specified period such as “net 30 days.” This arrangement creates an asset for the selling business called Accounts Receivable, representing the money owed by customers. Unlike cash sales where payment is immediate, selling on account defers the cash inflow, essentially extending credit to the customer. The transaction is recorded by debiting Accounts Receivable and crediting Sales Revenue in the business’s accounting records, reflecting the earned revenue even before cash is received.

Implications of Unpaid Customer Balances

The primary financial concern with selling on account arises when customers fail to pay their outstanding balances, leading to uncollectible accounts. This represents a direct loss of anticipated revenue. Uncollected payments significantly strain a business’s cash flow, making it challenging to meet its own financial obligations, such as paying suppliers, employees, or rent.

Businesses incur additional costs when pursuing overdue payments. These expenses include time and resources for collection efforts, such as engaging collection agencies or legal counsel. Uncollectible amounts reduce a business’s profitability and necessitate write-offs, impacting financial statements by decreasing reported income and assets.

For tax purposes, businesses can often claim a bad debt deduction for worthless amounts, provided certain criteria are met. This deduction can reduce taxable income, offering a slight offset to the direct loss of revenue.

Financial Oversight of Accounts Receivable

To monitor and manage outstanding customer debts, businesses utilize various financial tools and metrics. An “aging report” is a common tool that categorizes outstanding balances based on how long they have been due, typically in increments such as 1-30 days, 31-60 days, and 90+ days past due. This report highlights older debts, which are generally more difficult to collect, allowing businesses to prioritize collection efforts.

Key financial metrics, such as Days Sales Outstanding (DSO) and Accounts Receivable Turnover Ratio, provide insights into the efficiency of a business’s collection process. DSO measures the average number of days it takes for a business to collect revenue after a sale, indicating how quickly customer payments are converted to cash. The Accounts Receivable Turnover Ratio reflects how many times a business collects its average accounts receivable balance within a given period, signifying the effectiveness of its credit and collection policies.

Businesses often employ an “allowance for doubtful accounts,” which is a contra-asset account used to estimate and reserve for potential uncollectible amounts. This accounting practice reflects the anticipated losses from selling on account directly on financial statements, providing a more accurate representation of the net realizable value of accounts receivable. This allowance serves as a proactive measure to account for the inherent risk of non-payment.