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Accounts Receivable Defined

Unless you work in accounting, you might not understand exactly what the words “account receivable” actually mean.  Often shortened to A/R or AR, accounts receivable constitutes the money owed to a business.  In contrast, accounts payable is a reference to the money the business pays to other businesses and entities.

A Plain English Explanation of Accounts Receivable

The vast majority of businesses sell products and services to clients on credit.  This means the value offering is not paid for at the time it is provided.  Rather, the service or product provider issues a bill that is eventually paid by the client.  This payment is processed through the provider’s accounts receivable department.  Accounts receivable are the account within financial books that keep track of the entirety of money owed by customers.  The money owed to a business is usually collected in a specific period of time, be it a couple weeks, a month or longer.  The expectation is that the money owed will be paid.  Therefore, money owed to the business is recorded as an asset on the balance sheet.  This means accounts receivable is used as an integral component of the accrual basis method of accounting.  The logic in categorizing accounts receivable as an asset is the money owed is likely to be paid within a reasonable amount of time and provide value to the business. 

Accounts Receivable in the Context of Revenue

Accounts receivable is considered an asset account as opposed to a revenue account.  Accrual accounting records revenue at the same moment in time accounts receivable payments are recorded.  This means two entries are necessary to record a single transaction.  Alternatively, with cash basis accounting, there is no accounts receivable.  This accounting approach does not count transactions as sales until the cash actually reaches the bank account.

What if Accounts Receivable Payments are not Provided?

Though most money owed to accounts receivable is paid in due time, some payments are not provided.  These unpaid debts are referred to as bad debts.  In such an instance, an allowance for uncollectible accounts is used.  The logic in establishing an allowance for uncollectible accounts is to ensure the accounts receivable figures used on financial statements are not egregiously higher than they should be.  Money owed to a business that is not paid is written off as a bad debt expense, triggering a debit to the allowance for uncollectible accounts. 

Keep in mind, the allowance for uncollectible accounts account is merely a rough estimate as to the amount of money that will not be collected from clients.  Once the uncollectible accounts are properly justified, the accounts receivable pertaining to those unpaid debts can be credited by the amount owed, decreasing the money owed by the amount written off and determined to be uncollectible.  If the client ends up paying the money owed after it is written off as a bad debt, a debit must be made to accounts receivable to properly record the transaction.  Revenue is also credited by the amount paid.

The Importance of Accounts Receivable

Accounts receivable is important as it keeps track of exactly how much money is owed to a business in an organized and detailed manner.  Accounts receivable empowers your business to keep track of exactly how much money is owed, how much money is paid on time, the amount of money paid late and even the amount of money paid well ahead of the due date.  Segmenting clients into groups based on their payment history makes it easier for your business to excel, ultimately narrowing your client base to those who actually pay and excluding non-payers from benefiting from future service. 

Stay on top of your accounts receivable payments as well as the non-payments and you won’t have to worry nearly as much about potential cash flow issues.  In other words, the prudent use of accounts receivable sets the stage for your business to restrict services to paying clients, ensuring you don’t run low on cash or run out of cash after providing services without receiving payment.  Accounts receivable should be viewed as a current asset as it gauges a business’s liquidity and ability to meet debt obligations in a certain period of time without implementing extra cash flows.   

Accounts receivable is often relied upon by fundamental analysts in terms of turnover, commonly referred to as accounts receivable turnover ratio.  This ratio measures the number of times a business has collected on the accounts receivable balance during a specific accounting period.  This analysis can be taken one step further, including outstanding analysis of days sales to gauge the average period of time it takes for collection of accounts receivable balances to occur across a specific period of time.

Accounts Receivable in Action

Consider an example of accounts receivable in action to expand your understanding of this accounting term.  For instance, if a roofing business bills a client after working on his or her roof, the company proceeds to record an account receivable for the invoice that has yet to be paid.  The roofer waits for the customer to pay the bill, assuming that client will honor his or her word.  This credit-based sales is quite common as it makes it easier to bring new clients into the fold.  After all, clients don’t want to make a payment every single time a transaction occurs, especially if there are recurring expenses. In the end, using accounts receivable proves mutually beneficial to businesses as well as clients.

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