What is accounts receivable? Everything you need to know

You’ve probably heard of accounts receivable, but do you know what it is?

Accounts receivable is a concept in accounting that refers to money a company expects to receive at a future date.

Read on to find out more about accounts receivable, how to record it for reporting purposes, and a number of options you can consider when dealing with any overdue or outstanding payments.

Accounts receivable definition

Accounts receivable refers to your company’s invoices that have not yet been paid at the time of reporting. Similar to a line of credit extended to a customer, accounts receivable serves as a payment agreement between your business and its clients. Though specific terms vary, an account receivable is typically set to be paid within anywhere from one day to one year of the invoice date.

A broader accounts receivable definition refers to any money owed to a company—any unpaid invoices define a company’s accounts receivable.

Accounts receivable management is a key part of a company’s accounting practices. Offering your customers a sale on credit can help build healthy business relationships with repeat buyers, avoiding the hassle and paperwork of frequent invoicing.

What funds are considered accounts receivable?

Depending on which accounting standard you’re using, the accounts receivable total is classified in slightly different ways.

Businesses in the US use GAAP (Generally Accepted Accounting Practices). In this system, the accounts receivable balance in your financial reporting has to equal the total amount of money you expect to collect from customers (the “net realizable value”) within a given reporting period. This balance should not include any bad debt. 

In other countries worldwide, including the EU, UK, Canada, and Australia, the IFRS (International Financial Reporting Standards) system is used. In this framework, accounts receivable is the money you expect to collect on outstanding invoices within the next twelve months.

What type of account is an accounts receivable?

An accounts receivable is an asset account. That’s to say, accounts receivables denote money owed to you by a customer, so they count as a current asset on the balance sheet.

Specifically, under the accrual accounting system, every time you make an entry in accounts receivable, you also debit the amount in the accounts receivable account and credit the revenue account.This is as opposed to the cash-based accounting system, which only records revenue when cash comes in and expenses are paid (and therefore doesn’t use account receivables).

Why are accounts receivables important?

It’s common business practice to deliver goods or services and then send an invoice with a later payment date. For large orders, a deposit may be needed, but usually, no immediate, full payment is made.

Unfortunately, not all customers pay their bills on time. This can cause problems, particularly if you’re a smaller business whose livelihood depends on a few customers.

But it’s not just small businesses that need to focus on overdue bills. According to a study by US Bank, 82% of business bankruptcies are caused by cash flow problems. Sluggish invoice payments are a major reason such problems develop.

So, it’s crucial to keep on top of how much money is owed to your business and by which customers. Recording the details in accounts receivable allows you to keep track and take action to recover money owed. With effective accounts receivable management, you can take control of your cash flow by streamlining payments and invoicing, improving your customer relations in the process.

Understanding accounts payable vs accounts receivable

Another important aspect of dealing with payments is the distinction between accounts payable versus accounts receivable. Accounts payable is the mirror image of accounts receivable because it records money your company owes.

Assuming both parties use accrual accounting, every business transaction generates an entry into accounts payable at the customer end and accounts receivable on the supplier side.

Let’s say company A places an order with company B worth $1,000. Company B supplies the goods to company A and sends an invoice for that amount to be paid within 30 days.

At that point, the following two things happen:

• Company A records the transaction by entering $1,000 into accounts payable.
• Company B records the transaction by entering $1,000 into accounts receivable.

As company A has its house in order, it pays quickly. Two weeks later, in fact. So, 14 days after the goods were delivered:

• Company A removes the $1,000 from accounts payable and debits the cash account by the same amount.
• Company B removes the $1,000 from accounts receivable and credits the cash account by the same amount.

Monitoring accounts receivable and accounts payable is good business practice. It also ensures good cash flow and helps you understand your company’s overall financial health.

What is the accounts receivable turnover ratio?

The accounts receivable turnover ratio indicates how fast, on average, your customers pay the invoices you send out.

This is obviously a very important figure to know. You can use it to forecast cash flow, which helps you predict future cash positions, avoid cash shortages and make sure you use any spare cash efficiently.

The accounts receivable turnover formula is pretty straightforward. Divide your total net sales by the average accounts receivable to work out the ratio.

First, specify a time period. Let’s use one year as a typical example. Suppose you have $5,000 in accounts receivable at the start of the year and $4,000 at the end. To work out the average, add them together and divide by 2.

($5,000 + $4,000) / 2 = $4,500

If you make net sales of $90,000 during that same year, here’s how the accounts receivable turnover ratio calculation would look.

$90,000 / $4,500 = 20

From here, it’s a short step to calculating how long it takes, on average, for customers to pay you. Simply divide the number of weeks in the year by the turnover ratio.

52 / 20 = 2.6

This means that, on average, your customers settle their invoices in just over 2½ weeks. Tracking this number is crucial for monitoring cash flow. If it begins to drift, there could be an issue with slow payments that you should address before it becomes a problem.

Accounts receivable example

Here’s an example of how to record payments using accounts receivable:  

Imagine you run a business supplying components to a computer manufacturer.

They place an order for $5,000 worth of components. You deliver the goods and issue an invoice for this amount, with an instruction requesting payment within 30 days.

At the same time, you record a debit of $5,000 into accounts receivable, which stays there until the customer pays the invoice. You also record $5,000 as a credit in your cash account.

When the customer pays, you credit $5,000 to accounts receivable and debit $5,000 to the cash account.

But what if that $5,000 payment arrives so late that you’ve already written it off as a bad debt? You’ll need to get it back on the books in this scenario. To do this, you first debit $5,000 to accounts receivable and then credit revenue by $5,000.

What if they don’t pay?

If a customer is very late in paying, you don’t need to jump straight to writing the money off. That said, there are a few prudent steps it’s wise to take when this happens.

Avoid doing further business with late payers

If a company is slow to pay once, it’s possible they’ll make a habit of it. It’s standard practice to decide on a cut-off period—say, 90 or 120 days—at which point you will do no further business with the late payer until the debt is settled. This shows that you’re serious, which can sometimes be enough to nudge customers into paying.

Formally convert the outstanding invoice into a loan

If the late payer is a customer of good standing, you’ll probably want to give them some leeway. In this case, what you can do is convert the account receivable into a long-term note. In other words, you change its status into an official debt due in over 12 months’ time, and you begin to charge interest on it.

Enlist the help of professional collectors

Another option is to hire a collection agency to collect the debt. However, this should very much be a last resort because these agencies tend to take a substantial cut for their services. Often, you may end up not getting very much money back. Generally speaking, agreeing with late-paying customers is usually the preferable option.

None of these options is guaranteed to be effective, so if all else fails, it may be time to write the account receivable off as a bad debt.

These five tips will ensure consistent and timely payment of your accounts receivable.

When an account receivable becomes bad debt

Eventually, you’ll have to write a receivable off as bad debt if the customer doesn’t pay. You should always allow some contingency for this, as it’s common for a small percentage of debts to go bad. 

What defines a bad debt? In practice, it generally means a debt that would cost more to collect than it’s worth. Or a debt that for some reason has become impossible to collect, for example, if your customer goes bankrupt.

For reference, the IRS includes the following categories of assets that can become bad debts in its tax guidance:

• loans to clients and suppliers
• credit sales to customers
• business loan guarantees

If you do decide to write an account receivable off as bad debt, this is how to record it on the books.

Before the relevant accounting period, estimate the proportion of annual revenue you expect to be unable to collect. Include a credit entry for “allowance for uncollectible accounts” in your accounts (set off by the same amount debited to “bad debt expense”).

In the above example, if the customer doesn’t pay, that would mean crediting $5,000 to accounts receivable, but instead of debiting it to the cash account, you’d debit it to the allowance for uncollectible accounts.

Streamline AR management with accounts receivable software

With efficient accounts receivable software, you can automate and simplify your payment collection process. AR automation software allows customers the convenience of paying online in multiple currencies and recording payments effortlessly with automatic, real-time updates of accounts receivable.

Send out payment reminders to customers automatically as invoices become due and offer easy self-service options for your clients’ convenience. The software makes it straightforward to reconcile payments and link documents to customer accounts, saving time and freeing up your team to concentrate on what they do best — delivering top-tier service. 

You can also use advanced analytics to monitor trends in your payment data, which will help inform your business strategy. The software integrates seamlessly with your CRM to track all your quotes, sales orders, and invoices on a single platform.