account receivable

What Are Accounts Receivable (AR)?

Accounts receivable simply means the amount a company will receive from its customers for goods and services it authorized to be purchased on credit. Often customers are allowed a short period (30 to 60 days) to pay the invoice for the goods and services. Sometimes, a customer may be given a year to pay the money.

The term receivable refers to the payment not being realized. That means the company must have an extended credit line for its customers. 

Why do account receivable matter?

invoice

Accounts receivable are very crucial to the working capital of any business. When they are too low, that could signal a business is not offering competitive terms to its customers. Additionally, this could be an indicator a business is not taking its customer relationship seriously. When receivables are too high, that could be a signal that a company is struggling financially or soon it will. Striking a balance is, therefore, crucial when it comes to accounts receivable.

Most businesses have guidelines that help them avoid too high AR. For example, a business may say a customer is not qualified to receive items on credit if he represents more than 10% of the account payable. Other companies protect themselves from too high AR by establishing cash reserves. 

It is worth noting that sometimes receivables can be used as collaterals for borrowing money. 

Remember that uncollectible receivables do not qualify as assets. The uncollectible amounts are reclassified to the allowance for doubtful accounts. This results in a reduction in receivables. It is for this reason why companies allow only trustworthy customers enough to pay. 

Note that a company can sell its receivables to agencies that primarily focus on collecting the owed amounts. 

What kind of account are accounts receivable?

Any amount owed to a business by its customers for goods and services delivered is account receivable. All account receivables are recorded on the balance sheet as current assets. This means the account balance is due from the debtor in a year or less.

For receivables that take more than a year to be collected, they are recorded as notes receivable on the balance sheet or long-term assets. Under the accrual basis of accounting, the account is offset by an allowance for doubtful accounts. This is because it is likely some receivables will never be collected. This allowance is an estimate of the total amount of bad debts related to the receivable asset.

What are accounts receivable examples?

invoice

Example one

A producer will record an account receivable when it delivers a load of goods to a customer on March 10, and the customer is allowed to pay in 30 days. From March 10 until when the company receives the money, the company will have an account receivable. The customer will have an account payable.

Example two

Robert wants to buy a $6,500 jacuzzi but does not have the money at the time of the sale. The jacuzzi company decided to invoice him and allow him 30 days to pay the money. During that period, the company would record $6,500 in its accounts receivable. When Robert finally pays the money, that money goes back to the cash flow or sales amounts.

Now, what if Robert fails to pay the money within 30 days? He will still owe the company the money, and the company would be out of the money. That is why accounts receivable is recorded differently than sales.

The company may contact Robert if he fails to pay or contact a collecting agency to do so.

What is the journal entry for account receivable?

tracking record

As per the accrual accounting, you record a transaction whether cash has been received or not. You use this system to record account receivables. You can use accounting software that automatically creates an entry to credit the sales account and debit the AR account.

Once the customer pays the invoice, the cash account is debited, and the accounts receivable account credited.

Recording account receivable on the balance sheet

balance sheet

To help you understand how accounts receivable end up on a balance sheet, let’s consider the example below.

Imagine Walmart wants to order a new special-edition boxed set of Lord of the Rings books from publisher X.

Walmart negotiates to buy 50,000 units at $40 per set that won’t be available anywhere else. The books are printed and packaged. Walmart will sell the sets for $95 each to its clients.

When the publisher ships the units to Walmart, it attaches a bill for $2 million (50,000 x $40). Walmart then receives the books, but the publisher is still legally entitled to the money that hasn’t yet been paid.

That $2 million sits on the publisher’s balance sheet as an account receivable. On Walmart’s side, the amount sits as both an inventory asset and a liability (account payable).

Why are payment terms crucial?

Payments terms are very crucial for businesses that sell products on credit. These terms help such businesses do the following professionally:

  • Set the due payment dates. Often many businesses express those numbers as “Net 10,” “Net 30,” “Net 60,” or “Net 90.” For example, “Net 30” means 30 days from the time of the invoice to clear the balance.
  • Set late fees that apply to all those who fail to pay on time.
  • Formulate guidelines on how to approach customers who fail to pay. This can include how to adjust payment dates, when to take legal actions, when to offer an early-pay discount to speed up payment, or when to contact a collection agency.

An alternative to accounts receivable 

The best alternative to AR is getting paid upfront. This means no accounts receivable on your end but a liability on your balance sheet. In other words, you record prepaid revenue or unearned revenue. So, how is unearned revenue transferred from unearned revenue to sales revenue on the income statement? To help you understand this, consider the example below:

Clients often pay fees to a Registered Investment Advisor quarterly, billed in advance. The advisory company receives the cash but hasn’t yet earned that cash. For each business day that passes, a certain percentage of fees becomes earned and non-refundable.

As you can see, this approach reduces liability and increases reported sales. Have you tried this approach? If yes, did it work for your business? If you have not tried it, you still have a chance to try it.