When it comes to Accounts Receivable the old idiom of the carrot and the stick can be applied for maximum effectiveness. In Part II we discussed early payment discount terms, which are the carrot, pay early and receive the reward of paying less money. But that does not always work. Sometimes it requires punishment or threat thereof, i.e. the stick, to receive payment within your established and agreed upon terms. (Pay by this date or pay extra money.)
To provide some gentle ‘stick’ encouragement, many companies use overdue interest charges on invoices that are not paid within the credit terms.

While it is a very common practice to charge a small percentage for overdue invoices to encourage payment, the strict legality of such charges can vary from jurisdiction to jurisdiction. There can be laws that limit when you can charge interest, how much you can charge, or even if you are entitled to collect it through legal action. If you do intend to charge interest on overdue accounts, be certain those charges are clear when you negotiate the credit terms with your client. The client agreeing to the terms and conditions, i.e. overdue interest, will be an important factor in determining collectability should it ever come to that worst case scenario.
Regardless, it can also be effectively used to help prevent invoices from going past terms in the first place.
First, clearly state on every invoice what charges will be incurred for invoices paid after the due date. This is most effectively handled in a fine print message on the form itself. It is separate from the credit terms as that may vary (some customers may be Net 30, others Net 45, etc.) but your overdue interest charges are normally a company-wide standard.

Accounts not paid within terms are subject to a 2% monthly finance charge.
This establishes the first warning of the penalty for not paying the invoice on time. The next warning comes when the customer is sent a statement.

Customers should be sent statements on a regular basis, most companies choose to do it on a monthly basis. A similar message to the above should appear on all statements as a reminder of the penalty for not paying within the agree terms.

If the first two stages of warning on the invoice and statement do not work and the account enters a past due position, you will then start charging the interest.

Oneir provides two different ways to add interest to an account. One will only print the interest charged to the statement itself, the other posts an invoice to the customer’s account for the interest charge. To the customer there is no difference, they will see that they are being charged interest on the overdue amount either way, both will result in roughly the same charges. Both are equally valid, but with different benefits. Which you choose depends on which better suits your company.

Print On Statement Only Option

This method will calculate the percentage of interest charged based on any overdue amounts and how long they are past due and present a dollar value owed. Interest is charged from the first day the invoice is past the terms to the end date of the statement. If you wish you may build in a grace period by increasing the number of days overdue (from default of 1) when asking for the statements to print. But simply put, the larger the interest total, the more effective it can be in encouraging payment, so calculating from day one past due may be more effective than with a grace period.

This charge will post no record on the account or affect your accounting books in any way. It is merely meant as a prod to get payment. If the customer remits with the finance charge, it can of course be accommodated when recording the payment.

This method is very effective to prompt payments but since there is nothing posted, if you do not receive payment for the interest, there is no further action needed. For example if you send a statement with a finance charge printed on it, and within an acceptable, number of days the customer pays all past due invoices, but does not pay the finance charge. You may want to forgive the interest in those cases. If it was just printed on the statement you need to take no action to forgive the interest.

If your company frequently only collects interest if the customer pays it, this is probably the best method for you.

Post Finance Charges Invoices

This method uses similar formulas to calculate the interest, but will post an invoice transaction for the amount calculated. These specially numbered invoices will appear as receivables on the account and age just like any other invoice. When payment is received these invoices can be paid like any other outstanding invoice. Company policy will dictate whether payment should be applied against the interest invoices or original invoices first. The disadvantage is that if you decide to forgive the interest, an actual credit must be posted to write off the finance charge invoice.

From an accounting perspective it will also record as revenue and increase your Accounts Receivable asset each time the finance charges are posted.

If you company frequently receives payment for the interest charged this is the best method to use.

Read Accounts Receivable Management: Part IV Using Overdue Interest to Encourage On Time Payments
Read Accounts Receivable Management: Part II – Credit Policy
Read Accounts Receivable Management: Part I – Overview