Financial accounting and tax principles: Bob Scarlett explains the range of credit-control methods available to firms at a time when customers are finding it increasingly hard to pay up.

"In good economic times, late-paying clients are one of the headaches of doing business. But during a downturn, when sales slow, delinquent accounts can quickly turn into cash-flow killers. The challenge is to collect without alienating customers."

Business Week, May 21, 2001.

The number of unpaid bills has surged in recent months as the global recession takes hold. The increasing inability of both individuals and businesses to pay off their debts soon results in cash-flow problems and insolvencies for their creditors. A survey of credit controllers in February by the Credit Research Foundation found that 78 per cent had experienced a slowdown in payments from business customers. Microsoft, for example, reported that payments were generally arriving between 15 and 60 days later than they had been a year before.

The credit controller's role becomes more important in such challenging times. On the one hand, the immediate problem is to collect outstanding receivables as quickly as possible. On the other, insensitive tactics can fatally harm a customer relationship that may have taken years to develop.

Prevention is the first step in effective debtor management. Preventive measures include the following:

* Applying stricter credit appraisals to new and existing customers. In some cases this will cause established customer credit lines to be cut back or new credit lines to be refused.

* Writing stricter and clearer credit terms into sales agreements. The period of credit allowed on new sales may be cut back or more rigorous conditions--for example, payment by direct debit--may be required.

* Allowing established customers to pay by agreed instalments and offering them discounts for prompt payments.

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Such measures can prevent an uncontrolled expansion of receivables and the cost in terms of loss of customer goodwill is not always high. That said, they are not always cost-free. UK banks, for example, acted quickly at the onset of the credit crunch to tighten their lending criteria and cut back on their customers' overdraft facilities. This was intended to improve the quality of their loan books and reduce their exposure to doubtful debts. Yet the measures forced a significant number of customers out of business and caused distress to others. This did not attract good publicity for the banks concerned.

Effective preventive measures alone will not eliminate a receivables problem in a recession. Ultimately, debt collection is an issue that has to be addressed. The 2001 Business Week article, entitled "Make them pay" (www.snipurl.com/gzjk5), reported the case of a Minneapolis recruitment firm that had a major customer which had built up a large debt. The firm's manager stated: "My strategy is to maintain the relationship, so I use a light approach." He continued giving the customer credit, but sent it copies of unpaid old invoices along with new ones. He maintained persistent but gentle pressure on the customer to clear the arrears. Eventually, interest was added to arrears that were over 60 days old. Six months elapsed before the outstanding money came in, but the firm achieved this without impairing an important and long-standing customer relationship.

Standard practice when confronted with overdue receivables from an established customer is to take complaints progressively higher up its chain of command. An initial representation to the cashier may elicit a payment if the problem is only some administrative delay. If this fails to produce a result, the next point of contact is the chief accountant. Only if that intervention fails does the chief executive need to get involved. A hard, direct approach to the CEO may produce a quicker result, but it may come at the expense of the business relationship.

A supplier may be able to negotiate some form of "payment in kind" or barter with the debtor. Business Week reports one recent case where an accountant agreed to reduce the amount she was owed by a client--a vet--when the latter performed emergency surgery on her cat.

One ultimate solution is to pass outstanding receivables to a debt-collection agent. Such agents normally work on commission, taking between a fifth and a half of what they obtain. They may also add "administration charges" on to the receivable balances that they attempt to collect. As the full effects of the recession are felt this year, it's likely that increasingly large amounts of debt will be referred to collection agents. They will usually try to distinguish between the "can't pays" and "won't pays". There is little point in pursuing a debtor that's simply unable to pay, such as a firm in liquidation, so agents tend to focus on those debtors that appear to have the means to pay.

Debt-collection agents have no interest in maintaining any form of customer relationship with the debtor, of course, so the tactics they use are rarely gentle. Their initial approach to the debtor will normally be a letter making a short, peremptory request for payment, accompanied by the threat of legal action. If a payment is not immediately forthcoming, further correspondence will be sent, which will usually involve the addition of administration charges and interest to the total owed.

Most agents are prepared to negotiate a payment schedule involving instalments. Some may even offer to arrange a loan for a debtor in order to allow it to pay the amounts immediately owed to the agent's client. Such loans are likely to have extremely unattractive terms. Other tactics used by agents may involve personal visits or repeated telephone calls to the debtor. In the case of a business debtor, the calls may even be directed to the CEO's home.

The methods used by collection agents are governed by legislation in a number of key respects. Their UK trade body, the Credit Services Association, has a code of practice to which its members should adhere. But the Office of Fair Trading has frequently criticised measures such as:

* Threatening debtors with court action or bankruptcy when they know that such action is unlikely to be taken.

* Telephoning individuals at unreasonable times when they have not been given permission to do so.

* Pursuing claims for debts that are genuinely in dispute.

Although such actions are not always strictly unlawful, they are considered improper. An agent going a little too far with such tactics can fall foul of the law on harassment or intimidation. In their defence, some agents have drawn attention to irresponsible behaviour by debtors--for example, evading debts through prevarication or conducting frivolous disputes.

The use of collection agents can be a highly effective way to deal with outstanding receivables when all conventional methods have failed. But this will almost invariably signal the end of any form of relationship with the customer. A business that makes extensive or over-enthusiastic use of collection agents may gain a reputation that will scare off many prospective customers.

The management of overdue debt contains three key elements: prevention, negotiation and collection. The credit manager should pursue all three in a sensitive manner that seeks to resolve immediate cash-flow problems without jeopardising their company's long-term customer relationships and public image.

The individual measures I have covered should all form part of a well-defined debt-collection policy. None of them should be applied in isolation. This policy will need to be reviewed--and possibly tightened--in light of the credit crunch and the generally poor economic conditions.

Exam practice

Try the following question to test your understanding. The answer will be published in the next issue of Velocity, CIMA's student e-magazine (www.cimaglobal.com/velocity).

A company called Dosh provides materials and services to a large number of restaurants, bars and cafeterias in its local area. It is in established relationships with most of its customers, although new ones do appear occasionally. The new customers are mostly facilities opening in the area for the first time or are temporary facilities relating to one-off events. As is customary in the catering trade, Dosh normally invoices its customers on 30-day credit terms.

In recent months Dosh has been experiencing problems arising from the late payment of invoices. The industry is experiencing a cyclical downturn and a number of customers appear to be easing their cash-flow position by delaying payments to suppliers.

Dosh's management team is thinking about introducing a system of discounts for early payment and penalties for late payment. The following regime has been proposed, based on a 360-day year:

* Payments made within the 30-day credit period allowed are awarded a discount based on the number of days early the payment is received and an eight per cent annual interest rate.

* Payments made after the 30-day credit period allowed are charged a penalty based on the number of days late the payment is received and a 12 per cent annual interest rate. You are required to:

A Calculate the discount awarded on a 10,000 [pounds sterling] invoice paid 12 days early (two marks).

B Calculate the penalty charged on a 10,000 [pounds sterling] invoice paid 17 days late (one mark).

C Discuss the advantages and disadvantages that such a system might offer to Dosh (two marks).

Bob Scarlett is an accountant and consultant.