What is accounts receivable (AR)? Overview, uses & examples

Accounts receivable (AR) is a crucial aspect of financial management for businesses that provide goods or services on credit. It represents the money owed by customers for products or services they have purchased but have not yet paid for. 

Understanding accounts receivable is essential for businesses to effectively manage their cash flow, assess their financial health, and make informed decisions. 

This article will explore the concept of accounts receivable, discussing its overview, uses, and practical examples to illustrate its significance in the day-to-day operations of businesses.

What is the definition of accounts receivable?

Let’s first take a look at an accounts receivable definition.

Accounts receivable (AR), often abbreviated as A/R, refers to the outstanding invoices and money owed to a company by its customers for goods or services sold on credit. 

Essentially, it represents the company's short-term claims on its customers arising from sales made on account. AR is considered a current asset on a company's balance sheet, as it is expected to be collected within a relatively short period, typically within one operating cycle or fiscal year.

Importance and impact

Accounting receivable plays a crucial role in a company's financial health and operations. Efficient management of your accounts receivable department ensures timely collection of receivables, which improves cash flow, liquidity, and profitability. Conversely, poor AR management can lead to cash flow problems, increased bad debt expense, and financial instability.

Is accounts receivable an asset?

This Chaser article on ‘is accounts receivable an asset?’ answers this question in detail.

What does accounts receivable do and why do companies need it?

Accounts receivable (AR) is the lifeblood of many businesses, representing the outstanding invoices for goods sold or services rendered but not yet paid for by customers. It's a critical component of a company's financial health, impacting cash flow, profitability, and overall financial stability.

• Tracking and managing customer debt: AR meticulously records each customer's debt, including the invoice amount, due date, and any applicable terms. This detailed tracking allows businesses to monitor outstanding balances, send timely payment reminders, and follow up on overdue accounts.
• Facilitating credit sales: AR enables businesses to offer credit terms to their customers, allowing them to purchase goods or services now and pay later. This can be a powerful sales tool, attracting customers who might not otherwise be able to afford a full upfront payment.
• Enhancing cash flow visibility: By closely monitoring AR, businesses can gain valuable insights into their expected cash inflows. This allows them to anticipate potential cash shortages and take proactive steps to ensure they have sufficient funds to cover their expenses.
• Supporting financial reporting: AR is a key component of a company's balance sheet, representing a significant asset. Accurate AR reporting is essential for providing a clear picture of a company's financial position to investors, lenders, and other stakeholders.

Why do companies need effective accounts receivable management?

Accounts receivable plays a pivotal role in a company's operations and financial well-being.

• Boosting sales and revenue: By offering credit terms, businesses can attract a wider customer base and increase sales volume. This can lead to higher revenue and profitability, especially for businesses that sell high-value goods or services.
• Maintaining positive cash flow: While credit sales can boost revenue, they can also create cash flow challenges if customers don't pay on time. Effective AR management ensures timely collections, minimizing the risk of cash flow disruptions.
• Strengthening customer relationships: AR can help businesses build stronger relationships with their customers by offering flexible payment options and providing clear and transparent billing. This can lead to increased customer loyalty and repeat business.
• Mitigating credit risk: By carefully evaluating customer creditworthiness and setting appropriate credit limits, businesses can minimize the risk of bad debt and financial losses.
• Improving financial planning and forecasting: AR data provides valuable insights into a company's expected cash inflows, enabling more accurate financial planning and forecasting. This can help businesses make informed decisions about investments, expenses, and other strategic initiatives.
• Enhancing investor and lender confidence: Strong AR management demonstrates a company's financial discipline and ability to manage its assets effectively. This can boost investor and lender confidence, making it easier to secure funding and support.

5 real-life examples of accounts receivable

To help you fully understand how a/r in accounting are used in a business setting, and their importance, below are five examples of accounts receivable that might occur in real life:

1. A clothing retailer sells a $200 dress to a customer on credit. The customer promises to pay for the dress within 30 days. The $200 amount owed by the customer is recorded as accounts receivable on the retailer's balance sheet.
   
   
2. A construction company completes a $1 million project for a client. The client agrees to pay for the project in installments over the next 12 months. The $1 million amount owed by the client is recorded as accounts receivable on the construction company's balance sheet.
   
   
3. A law firm provides legal services to a client and bills the client for $5,000. The client agrees to pay the bill within 60 days. The $5,000 amount owed by the client is recorded as accounts receivable on the law firm's balance sheet.
   
   
4. A software company sells a software license to a customer for $10,000. The customer agrees to pay for the license in two equal installments of $5,000. The $5,000 amount owed by the customer is recorded as accounts receivable on the software company's balance sheet.
   
   
5. A medical clinic provides medical services to a patient and bills the patient for $200. The patient agrees to pay the bill within 30 days. The $200 amount owed by the patient is recorded as accounts receivable on the medical clinic's balance sheet.

Receivables in accounting: The process 

The management of customer accounts, payments, and invoices is essential to the accounts receivable (AR) process and a critical aspect of financial management for businesses that extend credit to customers.

Here's a step-by-step description of the AR process:

What is included in accounts receivable?

Step 1: Sales and invoicing

• When a customer makes a purchase on credit, a sales order is created.
• The sales order is used to generate an invoice, which is a document that details the goods or services sold, the price, and the payment terms.
• The invoice is sent to the customer, typically via email or mail.

Step 2: Recording the transaction

• The invoice amount is recorded as an accounts receivable in the company's accounting system.
• This increases the assets (accounts receivable) and revenue accounts.

Step 3: Payment processing

• When the customer makes a payment, it is recorded as a cash receipt in the accounting system.
• The accounts receivable balance is reduced, and the cash account is increased.

Step 4: Customer statements

• Periodically, customers receive statements that summarize their outstanding invoices, payments, and any past due amounts.
• These statements help customers track their accounts and make timely payments.

Step 5: Collections management

• The AR department is responsible for managing collections, including sending payment reminders, following up on overdue accounts, and initiating collection efforts if necessary.
• The goal of collections management is to minimize the days sales outstanding (DSO) and reduce bad debt expense.

Step 6: Accounts receivable aging report

• The AR aging report is a financial report that summarizes the outstanding invoices by their age.
• This report helps businesses identify overdue accounts and prioritize their collection efforts.

Step 7: Bad debt expense

• Bad debt expense represents the estimated amount of accounts receivable that are unlikely to be collected.
• This expense is recorded in the income statement and reduces net income.

Step 8: Year-End adjustments

• At the end of the accounting period, businesses review their AR balances and estimate any uncollectible accounts.
• Any necessary adjustments are made to the allowance for doubtful accounts, which is a contra asset account that reduces the value of accounts receivable.

Step 9: Reporting and analysis

• The AR department prepares reports that summarize the performance of the AR process.
• These reports include metrics such as DSO, collection efficiency, and bad debt expense ratio.
• This information is used to evaluate the effectiveness of the AR process and identify areas for improvement.

At what amount are accounts receivable recorded?

Accounts receivable are initially recorded at the invoice amount, which is the total value of goods or services sold to a customer on credit. This invoice amount typically includes the cost of the goods or services themselves, along with any applicable taxes, shipping charges, or other fees.

However, it is important to note that the initial recorded amount when accounting for receivables may need to be adjusted over time. 

For example, if a customer returns goods or receives a discount, the accounts receivable balance would need to be reduced accordingly. Additionally, if a customer is unable to pay their outstanding balance, the company may need to write off the receivable as a bad debt expense.

In order to ensure that accounts receivable are properly valued, companies typically implement a process for estimating and accounting for bad debts. This may involve analyzing historical data on customer payment patterns, as well as considering current economic conditions and other relevant factors.

What happens if customers don’t pay the due amounts?

Below are some actions you can take if customers don't pay their accounts receivable on time:

• Send payment reminders:
  • Politely remind customers of their outstanding invoices through emails, phone calls, or letters. Automation and the best accounts receivable software can help make this less of a burden on your AR team.
• Offer flexible payment options:
  • Provide customers with alternative payment methods or installment plans to make it easier for them to pay.
• Charge late payment fees:
  • Implement a late payment policy that charges interest or fees for overdue accounts.
• Utilize collection agencies:
  • Hire external collection agencies to recover delinquent payments on behalf of the company.
• Legal action:
  • As a last resort, companies may consider legal action such as filing a lawsuit against customers who persistently refuse to pay.

Key takeaways

Accounts receivable (AR) plays a critical role in a company's operations and financial well-being.

• Effective AR management can boost sales, maintain positive cash flow, strengthen customer relationships, and mitigate credit risk.
• Accurate AR reporting provides a clear picture of a company's financial position to investors, lenders, and other stakeholders.
• The AR process involves several steps, including sales and invoicing, recording the transaction, payment processing, customer statements, collections management, AR aging report, bad debt expense, year-end adjustments, and reporting and analysis.
• Companies need effective AR management to optimize cash flow, maintain financial stability, and make informed decisions about credit extension and collections strategies.

FAQs

Is it accounts receivable or account receivables? Which term is correct?

Accounts receivable is the correct term. Account receivables is incorrect.

Where do receivables go on a balance sheet?

Accounts receivable is an asset account and is reported on the balance sheet under current assets. Current assets are assets that are expected to be converted into cash within one year. Accounts receivable are considered current assets because they are typically due within a short period of time, such as 30 or 60 days.

When does a receivable become a bad debt?

A receivable becomes a bad debt when it is determined to be uncollectible. This can occur for a variety of reasons, such as:

• The customer is unable to pay due to financial hardship.
• The customer disputes the amount owed.
• The customer has filed for bankruptcy.
• The statute of limitations for collecting the debt has expired.

When a receivable is determined to be uncollectible, the company must write it off as a bad debt expense. This reduces the company's assets and net income.

What is accounts receivable turnover ratio?

Accounts receivable turnover ratio is a financial ratio that measures how efficiently a company is collecting its accounts receivable. It is calculated by dividing net credit sales by average accounts receivable. The resulting ratio indicates how many times the average accounts receivable balance is turned over during a period, typically a year.

A high accounts receivable turnover ratio indicates that a company is efficiently collecting its accounts receivable, while a low ratio indicates that the company may be experiencing problems with collections.

What are net receivables?

Net receivables are the total amount of money that a company is owed by its customers for goods or services that have been sold on credit, minus any allowances for doubtful accounts. In other words, it is the amount of money that a company expects to collect from its customers.

What is accounts receivable aging schedule?

An accounts receivable aging schedule is a report that summarizes the outstanding invoices of a company by their age. It is used to track the status of receivables and identify overdue accounts. The aging schedule is typically presented in a tabular format, with columns for the invoice date, due date, invoice amount, and days past due.

What is the allowance for uncollectible accounts?

What is the allowance for uncollectible accounts?The allowance for uncollectible accounts is a contra asset account that is used to reduce the value of accounts receivable. This account is established to reflect the estimated amount of accounts receivable that are unlikely to be collected. The allowance for uncollectible accounts is typically based on historical data on customer payment patterns, as well as current economic conditions and other relevant factors.

Are higher or lower accounts receivable better?

Lower accounts receivable are generally better for a company than higher accounts receivable. This is because lower accounts receivable indicate that a company is able to collect its payments from customers quickly and efficiently. This can lead to improved cash flow and reduced risk of bad debts.

On the other hand, higher accounts receivable can indicate that a company is having difficulty collecting its payments from customers. This can lead to cash flow problems and increased risk of bad debts. Additionally, higher accounts receivable can make it more difficult for a company to obtain financing, as lenders may be concerned about the company's ability to repay its debts.

When a customer pays with a credit card, is that cash or accounts receivable?

When a customer pays with a credit card, it is not considered cash. It is considered accounts receivable because the payment has not yet been received by the business. The credit card company will advance the funds to the business, but the business still owes the credit card company the amount of the purchase.

Can businesses sell their accounts receivable to a third party?

Yes, businesses can sell their accounts receivable to a third party in a financial transaction called accounts receivable factoring. Accounts receivable factoring, also known as invoice factoring, is a financial strategy where a company sells its unpaid invoices to a third-party financial institution, often called a factor, at a discount. This strategy provides the company with immediate cash flow, rather than waiting for customers to pay their invoices, which can sometimes take weeks or even months.