By Scott Beaver | Sr. Product Marketing Manager
Accounts receivable are cash amounts that clients owe your company. The goods or services have been delivered and the invoice sent. Now, it’s just a matter of time before you receive payment for a job well done.
If you’ve vetted your customers well and delivered the invoice properly, the money due will flow in as agreed with little or no further action on your part until it’s time to record payments. 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 from customers can cause cash flow problems and lead to difficulty obtaining loans and courting investors. That’s why you need to master the AR process.
What is Accounts Receivable?
Accounts receivable (AR) represent the amount of money that customers owe your company for products or services that have been delivered. AR are listed on the balance sheet as current assets and also refer to invoices that clients owe for items or work performed for them on credit.
- Accounts receivable are a current asset on the balance sheet.
- Accounts receivable represent money a company has invoiced for goods or services that have been delivered but not yet paid for.
- Accounts receivable are the flip side of accounts payable, which is money that a company owes to another business for products or services received.
Accounts Receivable Explained
Most businesses provide goods or services before they invoice their clients. The money owed in such a case is called an account receivable. The funds due are recorded as a current asset to offer insight into the financial condition of the company. In accrual-based accounting, AR represents value to the company, even though the money has not come into the company’s possession yet. Accrual-basis accounting recognizes income when it is earned rather than waiting for receipt of payment, as in cash-basis accounting.
Generally speaking, when both parties honor the terms of the transaction, the AR translates into bankable cash. If there is a delay in a receivable accounts conversion into payment on the customer side of the transaction, the value of the AR may deteriorate.
While invoices are sometimes lost or misdirected, financial instability, up to and including pre-bankruptcy conditions, is a large reason for customer late payments or defaults—and some companies simply have inefficient process for paying their invoices. This can lead to expensive collection activities and is also why some “pay later” transactions may require credit checks and other risk-mitigation efforts ahead of delivery of goods and services. Payment delays and AR value deterioration typically continue if collection activities are not promptly executed.
Accounts Payable versus Accounts Receivable
Accounts payable and accounts receivable are two sides of the same coin: Accounts payable represent money that a company owes to a supplier for goods or services purchased. Accounts receivable, in contrast, represent money coming in as payment for goods or services delivered 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 would record 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 accounts receivable to cover your expenses. A 1:1 ratio is a risky cash flow scenario because if a client does not pay as agreed, you can’t cover your own bills. This can initiate a spiral of increasing expenses due to late fees or an inability to operate because you can’t pay employees. A healthy business typically has an AR/AP ratio closer to 2:1. At 3:1, there is usually room for savings or reinvestment into the company.
Types of Accounts Receivable
Subcategories of accounts receivable can be divided by specific client accounts or to distinguish between types of goods and services. Some businesses also choose to split accounts 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 notes receivable 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 and circumstances.
- Notes receivable are are amounts your customer owes after signing a formal promissory notes to acknowledge the debt.
- Companies in housing or commercial real estate track rent receivables, which are amounts owed 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 would record that amount as an interest receivable.
Accounts Receivable Payment Terms
Accounts receivable payment terms refer to the date by which the customer agrees to remit payment. The most common payment term is net30, which means the customer agrees to pay the full amount of the invoice within 30 days. The typical range for payment terms is a few days to up to a full year. As customers, some large businesses will insist on net60 or even net90 terms.
Longer payment terms can put a small supplier in a tight spot if it is depending on that money to pay for overhead and other expenses. Cash flow management—control over how much money is coming or going—is one of the most significant factors in the success or failure of a company.
Why Is Accounts Receivable Important?
Since AR plays such an important role in cash flow management, maintaining an accurate record of accounts receivable is vital for understanding the liquidity of a company as well as its overall financial condition. Credit issuers and potential investors look closely at accounts receivable for financing decisions.
Accounts receivable financing is an arrangement that offers funding based on a portion of accounts receivable. Sloppy AR records could result in difficulty securing accounts receivable financing or a loss of confidence from potential investors.
Accounts Receivable (AR) Benefits
In accrual-based accounting, recording accounts receivable is critical to maintaining an accurate picture of a company’s assets on its balance sheet. Poor invoicing practices and AR records could lead to misunderstandings about your company’s cash position, which, in turn, could pose problems in paying expenses, misallocation of funds, audits, and difficulty securing financing or investors.
Accounts Receivable Workflow
To create a workflow for accounts receivable, a business must generate and send a bill to the customer. Depending on whether the client makes a timely payment, the company may apply discounts or fees as applicable.
After payment is received, it is recorded as a deposit. If payment is not received, the company 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 will pay to decide whether to write off the sale or apply additional fees and invoice again. Late fees of 1% to 1.5% are standard. Legal limits for the maximum amount of fees and interest that 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 the income statement as a sale or revenue—just the same as goods or services that were paid for immediately. Some accounting software will automatically compute accounts receivable as the user creates client invoices.
Funds that have been earned but not collected are accruals, so accounts receivable are recorded in accrual accounting. In cash accounting, the transaction would not be recorded until the client paid.
Accounts Receivable Examples
If Bob’s Plumbing Service visited a client’s office to repair a leak and invoiced the client for that service, Bob’s accountant would record the amount owed as an account receivable on Bob’s balance sheet.
As another example, Susie’s Catering Service delivers 100 box lunches to a recurring monthly company luncheon. Each month, Susie’s company records the total due under accounts receivable after she delivers the goods to her client.
What is the Accounts Receivable Process?
Essentially, the accounts receivable process begins with a purchase agreement where terms are set between a client and the company providing goods or services. Then, an invoice is issued, and the account receivable is recorded.
When the account is paid as agreed, it is recorded as a deposit and is no longer a receivable. If the account is not paid according to the terms of the agreement, the company begins 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 longer receivable.
- If the customer fails to pay, issue another invoice with any penalties as agreed at the time of delivery.
What is the Accounts Receivable Turnover Ratio?
The accounts receivable turnover ratio is the net credit sales for a given period divided by the average accounts receivable. The AR turnover ratio is used to determine a company’s efficacy at extending and collecting on credit with its clients. A high turnover ratio indicates that a business is more conservative in extending credit or more aggressive in collections.
This ratio can be used in conjunction with an allowance account or an allowance for doubtful accounts, which reflects the percentage of accounts receivable expected to be paid, to estimate future cash flow. An allowance account or an allowance for doubtful accounts is a contra asset; that is, it reduces the value of an asset in the general ledger to represent the cash the business expects to collect.
Where the AR/AP ratio demonstrates a company’s sales, the accounts receivable turnover ratio represents the efficiency of collections. With a healthy AR/AP ratio, your business is earning enough to cover expenses—even when clients default or pay late. A higher AR turnover ratio 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 for the work or products you have already delivered. Poor record keeping in accounts receivable could lead to problems in audits and bad business decisions due to misunderstandings about cash flow. However, with good invoicing and accounting practices, you will have a clear understanding of your company’s financial health to guide your business strategy, secure financing, or inform potential investors.