Accounts receivable are cash amounts that clients owe your company. The goods or serviceshave been delivered and the invoice sent. Now, it’s just a matter of time before youreceivepayment for a job well done.
If you’ve vetted your customers well and delivered the invoice properly, the money duewillflow in as agreed with little or no further action on your part until it’s time torecordpayments. However, no matter how efficiently you managed the process of extending credit,you may find yourself mired in collection activities. Late payments or non-payments fromcustomers can cause cash flow problems and lead to difficulty obtaining loans and courtinginvestors. That’s why you need to master the AR process.
Video: AP vs. AR
What is Accounts Receivable?
Accounts receivable (AR) represent the amount of money that customers owe your company forproducts or services that have been delivered. AR are listed on the balance sheet as currentassets and also refer to invoices that clients owe for items or work performed for them oncredit.
Key Takeaways
- Accounts receivable are a current asset on the balance sheet.
- Accounts receivable represent money a company has invoiced for goods or services thathave been delivered but not yet paid for.
- Accounts receivable are the flip side of accounts payable, which is money that a companyowes to another business for products or services received.
Accounts Receivable Explained
Most businesses provide goods or services before they invoice their clients. The money owedin such a case is called an account receivable. The funds due are recorded as a currentasset to offer insight into the financial condition of the company. In accrual-basedaccounting, AR represents value to the company, even though the money has not come into thecompany’s possession yet. Accrual-basis accounting recognizes income when it is earnedrather than waiting for receipt of payment, as in cash-basis accounting.
Generally speaking, when both parties honor the terms of the transaction, the AR translatesinto bankable cash. If there is a delay in a reciveable accounts conversion into payment onthe customer side of the transaction, the value of the AR may deteriorate.
While invoices are sometimes lost or misdirected, financial instability, up to and includingpre-bankruptcy conditions, is a large reason for customer late payments ordefaults—and somecompanies simply have inefficient process for paying their invoices. This can lead toexpensive collection activities and is also why some “pay later” transactionsmay requirecredit checks and other risk-mitigation efforts ahead of delivery of goods and services.Payment delays and AR value deterioration typically continue if collection activities arenot promptly executed.
Accounts Payable versus Accounts Receivable
Accounts payable and accounts receivable are two sides of the same coin: Accounts payablerepresent money that a company owes to a supplier for goods or services purchased. Accountsreceivable, in contrast, represent money coming in as payment for goods or servicesdelivered with payment terms. AP is considered a liability, and AR is an asset.
For example, if a company orders 50 reams of paper and receives a bill for $300, it wouldrecord that expenditure under accounts payable. The office supply company would record the$300 under accounts receivable because it is money the business will receive.
For a company to weather some missed or late payments, it needs a healthy ratio of AR to AP.Typically, a 1:1 AR/AP ratio means that you have just enough money coming in from accountsreceivable to cover your expenses. A 1:1 ratio is a risky cash flow scenario because if aclient does not pay as agreed, you can’t cover your own bills. This can initiate aspiral ofincreasing expenses due to late fees or an inability to operate because you can’t payemployees. A healthy business typically has an AR/AP ratio closer to 2:1. At 3:1, there isusually room for savings or reinvestment into the company.
Types of Accounts Receivable
Subcategories of accounts receivable can be divided by specific client accounts or todistinguish between types of goods and services. Some businesses also choose to splitaccounts receivable based on whether the promise to pay was an oral or written agreement.Accounts receivable are part of a larger group of receivables that also include notesreceivable and other receivables such as rent receivables, loans, term deposits and more.There are many types of receivables to account for a vast array of industries andcirc*mstances.
- Notes receivable are are amounts your customer owes after signing a formal promissorynotes to acknowledge the debt.
- Companies in housing or commercial real estate track rent receivables, which are amountsowed by tenants, typically on a monthly basis.
- Any loans to employees or other businesses result in loan receivables.
- If anyone owes your business interest as part of a payment plan, your accountant wouldrecord that amount as an interest receivable.
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Accounts Receivable Payment Terms
Accounts receivable payment terms refer to the date by which the customer agrees to remitpayment. The most common payment term is net30, which means the customer agrees to pay thefull amount of the invoice within 30 days. The typical range for payment terms is a few daysto up to a full year. As customers, some large businesses will insist on net60 or even net90terms.
Longer payment terms can put a small supplier in a tight spot if it is depending on thatmoney to pay for overhead and other expenses. Cash flow management—control over howmuchmoney is coming or going—is one of the most significant factors in the success orfailure ofa company.
Why Is Accounts Receivable Important?
Since AR plays such an important role in cash flow management, maintaining an accurate recordof accounts receivable is vital for understanding the liquidity of a company as well as itsoverall financial condition. Credit issuers and potential investors look closely at accountsreceivable for financing decisions.
Accounts receivable financing is an arrangement that offers funding based on a portion ofaccounts receivable. Sloppy AR records could result in difficulty securing accountsreceivable financing or a loss of confidence from potential investors.
Accounts Receivable (AR) Benefits
In accrual-based accounting, recording accounts receivable is critical to maintaining anaccurate picture of a company’s assets on its balance sheet. Poor invoicing practicesand ARrecords could lead to misunderstandings about your company’s cash position, which, inturn,could pose problems in paying expenses, misallocation of funds, audits, and difficultysecuring financing or investors.
Accounts Receivable Workflow
To create a workflow for accounts receivable, a business must generate and send a bill to thecustomer. Depending on whether the client makes a timely payment, the company may applydiscounts or fees as applicable.
After payment is received, it is recorded as a deposit. If payment is not received, thecompany may send another invoice to reflect the new balance with late fees.
If the client still does not pay, the business must determine whether the client can or willpay to decide whether to write off the sale or apply additional fees and invoice again. Latefees of 1% to 1.5% are standard. Legal limits for the maximum amount of fees and interestthat may be charged vary between states. If you stay below 10% of the balance due per year,you are unlikely to run afoul of the law.
How to Record Accounts Receivable
Accounts receivable are listed as a current asset on the balance sheet and included on theincome statement as a sale or revenue—just the same as goods or services that werepaid forimmediately. Some accounting software will automatically compute accounts receivable as theuser creates client invoices.
Funds that have been earned but not collected are accruals, so accounts receivable arerecorded in accrual accounting. In cash accounting, the transaction would not be recordeduntil the client paid.
Accounts Receivable Examples
If Bob’s Plumbing Service visited a client’s office to repair a leak and invoicedthe clientfor that service, Bob’s accountant would record the amount owed as an accountreceivable onBob’s balance sheet.
As another example, Susie’s Catering Service delivers 100 box lunches to a recurringmonthlycompany luncheon. Each month, Susie’s company records the total due under accountsreceivable after she delivers the goods to her client.
What is the Accounts Receivable Process?
Essentially, the accountsreceivable process begins with a purchase agreement where terms are set between aclient and the company providing goods or services. Then, an invoice is issued, and theaccount receivable is recorded.
When the account is paid as agreed, it is recorded as a deposit and is no longer areceivable. If the account is not paid according to the terms of the agreement, the companybegins a collections process.
Steps in The Accounts Receivable Process
- Deliver goods or services to your client.
- Invoice the customer.
- Record the invoiced amount as an account receivable.
- If the client pays as agreed, record the payment as a deposit. The account is no longerreceivable.
- If the customer fails to pay, issue another invoice with any penalties as agreed at thetime of delivery.
What is the Accounts Receivable Turnover Ratio?
The accounts receivable turnover ratio is the net credit sales for a given period divided bythe average accounts receivable. The AR turnover ratio is used to determine acompany’sefficacy at extending and collecting on credit with its clients. A high turnover ratioindicates that a business is more conservative in extending credit or more aggressive incollections.
This ratio can be used in conjunction with an allowance account or an allowance for doubtfulaccounts, which reflects the percentage of accounts receivable expected to be paid, toestimate future cash flow. An allowance account or an allowance for doubtful accounts is acontra asset; that is, it reduces the value of an asset in the general ledger to representthe cash the business expects to collect.
Where the AR/AP ratio demonstrates a company’s sales, the accounts receivable turnoverratiorepresents the efficiency of collections. With a healthy AR/AP ratio, your business isearning enough to cover expenses—even when clients default or pay late. A higher ARturnoverratio indicates that your business is doing a good job of collecting on invoices.
In essence, accounts receivable are a record of money your customers owe your business forthe work or products you have already delivered. Poor record keeping in accounts receivablecould lead to problems in audits and bad business decisions due to misunderstandings aboutcash flow. However, with good invoicing and accounting practices, you will have a clearunderstanding of your company’s financial health to guide your business strategy,securefinancing, or inform potential investors.
