Accounts Receivable

What is Accounts Receivable?

Definition: Accounts receivable (A/R) are amounts that customers owe for purchases that they made on credit with a company. In other words, it’s the amount of money customers owe a business for credit sales.

Accounts receivable is the amount owed to a company resulting from the company providing goods and/or services on credit. The term trade receivable is also used in place of accounts receivable.

Accounts receivable is the balance of money due to a firm for goods or services delivered or used but not yet paid for by customers. Accounts receivables are listed on the balance sheet as a current asset. Accounts receivable is any amount of money owed by customers for purchases made on credit.

Accounts receivable are legally enforceable claims for payment held by a business for goods supplied and/or services rendered that customers/clients have ordered but not paid for. These are generally in the form of invoices raised by a business and delivered to the customer for payment within an agreed time frame. Accounts receivable is shown in a balance sheet as an asset. It is one of a series of accounting transactions dealing with the billing of a customer for goods and services that the customer has ordered. These may be distinguished from notes receivable, which are debts created through formal legal instruments called promissory notes.

What Does Accounts Receivable Mean?

Most companies have an A/R system that allows customers to purchase goods or services on credit and pay cash for them at a later point in time. This strategy can increase sales, build customer relationships, and even create consumer loyalty. Even though these advantages are strong, companies must evaluate each customer on an individual basis to see if they are trustworthy enough to extend credit terms.

If the customer proves to be creditworthy, the advantages of creating an account for them will outweigh the risk that the customers will default on the purchase and the company won’t receive its payment.

Accounts receivable is recorded as a current asset on the balance sheet and is often viewed as one of the most liquid assets a company can own. Let’s take a look at an example of how to record a credit sale.

Example

Freidman, PC is a CPA firm that specializes in tax and consulting and allows its clients to pay on account. When a tax return is finished, Friedman sends an invoice to the client with credit terms that allow the client to pay the bill within 30 days.

On the day the tax return is finished and the invoice is printed, Freidman would debit account receivables and credit the revenues account for the job. Recording this entry agrees with the matching principle of accrual accounting because revenues are recorded when they are earned instead of being recorded when they are collected.

When the client pays his invoice, Freidman would record the payment by debiting cash and crediting the receivables account. This way the A/R balance is cleared out and the revenues recorded equals the cash received.

Why do Accounts Receivable matter?

Accounts receivable is an important factor in a company’s working capital. If it’s too high, the company may be lax in collecting what’s owed too it and may soon be struggling to find the cash to pay the bills; if it’s too low, the company may be unwisely harming customer relationships or not offering competitive payment terms. In general, accounts receivable leciels correspond to changes in sales levels.

Companies can sometimes use their receivables as collateral for borrowing money. The level of accounts receivable also affects several important financial-performance measures, including working capital, days payable, the current ratio and others.

It is important to note that uncollectible receivables do not qualify as assets (these uncollectible amounts are reclassified to the allowance for doubtful accounts, which is essentially a reduction in receivables); thus, companies usually allow only creditworthy customers to pay days, weeks or even months after they’ve received the company’s services or goods. Sometimes companies sell their receivables for cents on the dollar to other companies that focus solely on collecting the owed amounts.

What Kind of Account Is Accounts Receivable?

The amount of money owed to a business from their customer for a good or services provided is accounts receivable. Accounts receivable is recorded on your balance sheet as a current asset, implying the account balance is due from the debtor in a year or less.

If takes a receivable longer than a year for the account to be converted into cash, it is recorded as a long-term asset or a notes receivable on the balance sheet. Under the accrual basis of accounting, the account is offset by an allowance for doubtful accounts, since there a possibility that some receivables will never be collected. This allowance is estimate of the total amount of bad debts related to the receivable asset.

Payment Terms

An example of a common payment term is Net 30 days, which means that payment is due at the end of 30 days from the date of invoice. The debtor is free to pay before the due date; businesses can offer a discount for early payment. Other common payment terms include Net 45, Net 60 and 30 days end of month. The creditor may be able to charge late fees or interest if the amount is not paid by the due date.

Booking a receivable is accomplished by a simple accounting transaction; however, the process of maintaining and collecting payments on the accounts receivable subsidiary account balances can be a full-time proposition. Depending on the industry in practice, accounts receivable payments can be received up to 10 – 15 days after the due date has been reached. These types of payment practices are sometimes developed by industry standards, corporate policy, or because of the financial condition of the client.

Since not all customer debts will be collected, businesses typically estimate the amount of and then record an allowance for doubtful accounts which appears on the balance sheet as a contra account that offsets total accounts receivable. When accounts receivable are not paid, some companies turn them over to third party collection agencies or collection attorneys who will attempt to recover the debt via negotiating payment plans, settlement offers or pursuing other legal action.

Outstanding advances are part of accounts receivable if a company gets an order from its customers with payment terms agreed upon in advance. Since billing is done to claim the advances several times, this area of collectible is not reflected in accounts receivables. Ideally, since advance payment occurs within a mutually agreed-upon term, it is the responsibility of the accounts department to periodically take out the statement showing advance collectible and should be provided to sales & marketing for collection of advances. The payment of accounts receivable can be protected either by a letter of credit or by Trade Credit Insurance.

The Difference Between Accounts Receivable and Accounts Payable

Accounts receivable are the amounts owed to a company by its customers, while accounts payable are the amounts that a company owes to its suppliers. The amounts of accounts receivable and payable are routinely compared as part of a liquidity analysis, to see if there are enough funds coming in from receivables to pay for the outstanding payables. This comparison is most commonly made with the current ratio, though the quick ratio may also be used. Other differences between accounts receivable and payable are as follows:

  • Receivables are classified as a current asset, while payables are classified as a current liability.
  • Receivables may be offset by an allowance for doubtful accounts, while payables have no such offset.
  • Receivables usually only involve a single trade receivables account and a non-trade receivables account, while payables can be comprised of many more accounts, including trade payables, sales taxes payable, income taxes payable, and interest payable.

Many payables are required in order to create products for sale, which may then result in receivables. For example, a distributor may buy a washing machine from a manufacturer, which creates an account payable to the manufacturer. The distributor then sells the washing machine to a customer on credit, which results in an account receivable from the customer. Thus, payables are typically required in order to produce receivables.

Benefits of Accounts Receivable

Accounts receivable is an important aspect of a businesses’ fundamental analysis. Accounts receivable is a current asset so it measures a company’s liquidity or ability to cover short-term obligations without additional cash flows.

Fundamental analysts often evaluate accounts receivable in the context of turnover, also known as accounts receivable turnover ratio, which measures the number of times a company has collected on its accounts receivable balance during an accounting period. Further analysis would include days sales outstanding analysis, which measures the average collection period for a firm’s receivables balance over a specified period.

Summary

Define Accounts Receivable: Receivables means the money that customers owe a business for purchasing goods or services on credit.

Key takeaways:

  1. Accounts receivable is an asset account on the balance sheet that represents money due to a company in the short-term.
  2. Accounts receivables are created when a company lets a buyer purchase their goods or services on credit.
  3. Accounts payable is similar to accounts receivable, but instead of money to be received, it’s money owed.
  4. The strength of a company’s A/R can be analyzed with the accounts receivable turnover ratio or days sales outstanding.
  5. A turnover ratio analysis can be completed to have an expectation when the A/R will actually be received.