Bookkeeping 101: What is Accounts Receivable?
Many businesses and organizations sell goods and services to their customers on credit. Customers get their goods and services delivered to them, receive invoices, and are expected to fulfill them at the time stipulated in the invoices.
Businesses record the credits owed to them by customers in the accounts receivable ledger. There are a lot of businesses that do not sell goods and services on credit to customers for fear of non-payment.
What do you do when your customers refuse to pay accounts receivable? How do you prevent unfulfilled accounts receivable and get your customers to pay faster?
In this article, you will learn everything you need to know about accounts receivable, including other types of receivables.
Let's get started.
What is Accounts Receivable?
Accounts Receivable is the money that customers owe a business or company due to the purchase of goods or services. The money is always paid after the transaction has occurred.
Businesses often offer goods and services on credit to customers. They send an invoice (indicating the agreed patent time frame) alongside the goods, and then the customer makes necessary payments later.
Accounts Receivable is a small business bookkeeping basics that deals with the payment of goods or services already ordered by customers.
They are recorded under the asset section of a company's balance sheet. Accounts Receivable are found under the assets section because they are considered as something of value to a company, i.e. a future cash asset. It is listed as a current asset.
Differences Between Accounts Receivable and Accounts Payable
Accounts Receivable is the money owed to a business as a result of the purchase of goods and services on credit. It is categorized under assets in a balance sheet because it contributes to the value of the company.
On the other hand, Accounts Payable is the amount a business owes vendors or suppliers for the goods and services received that have not been paid for. The sum of all the money a company owes its suppliers is recorded under the accounts payable. It is recorded under the liabilities section of a company's balance sheet. The reason why it falls under the liability account is that it is money the company owes.
Accounts Payable and Accounts Payable are common terms used to describe business-to-business (B2B) transactions. For example, if your furniture company sends an invoice of $20,000 to a hotel for furniture you made for them, the hotel will record the purchase as Accounts Payable in their financial books. On your end, it will be recorded as Accounts Receivable because the hotel will have to make payments for the goods you supplied them.
Also, let's assume a saw-mill company supplied your furniture company with stacks of wood and sent an invoice of $5,000 with the product. The transaction will be recorded as Accounts Payable in your company books. It will be recorded as Accounts Receivable in the saw-mill company because they are expecting your company to pay for the goods you ordered.
Accounts receivable and accounts payable have some differences. Let us take a look at them.
- is an asset.
- adds value to the company
- is the money to be received by a company for the goods or services delivered to customers on credit.
- is a liability
- is paid with a company's asset
- is the money that has to be paid to suppliers for the goods or services your company acquired on credit.
Example of Accounts Receivable
A good example of Accounts Receivable is the money an electricity company bills its customers after supplying them adequate electricity. The electricity company records these bills under accounts receivable as they wait for customers to pay their bills.
Another example of accounts receivable is the money retail businesses owe manufacturing companies after the bulk supply of goods and services. The manufacturing companies would record the transactions as unpaid invoices under the account receivable while they wait for payments.
Most businesses and organizations operate on credit sales while providing goods and services to their esteemed customers. There would be an agreement between the companies and the customers reflected in the invoices written for such transactions.
Customers are expected to make payments within the agreed time frame. This practice allows customers to pay for goods and services at a more convenient time. Customers and businesses do not have to request loans from financial institutions such as factoring companies before ordering goods.
While some businesses offer this opportunity to special customers, some other businesses offer it to all their clients. There is often a reasonable level of trust between both parties before such transactions can occur.
Other Types of Receivables
Most businesses use at least four types of receivables. They are notes receivable, interest receivable, trade receivables, and non-trade receivable.
1. Notes Receivable
Notes receivable is a documented promise to receive money from a customer at a later date. The money is always made up of the principal amount and interest. Notes receivable, just like accounts receivable, is also an amount that customers owe a business.
For notes receivable, the customers will have to sign a note showing proof of the money they owe. Business owners can make use of the notes receivable to pursue legal steps if the customer fails to pay the debt within the agreed time.
Like accounts receivable, notes receivable are recorded under the asset column in a balance sheet. It can either be a current asset or a long-term asset. If the notes are due in a year or even less, it is considered a current asset. But if the notes are still active for more than a year, then it is considered a long-term asset.
2. Interest Receivable
Interest receivable is the yet-to-be-paid interest a company earns from loans, overdue invoices, and investments. In other words, it is the expected interest a company will receive at a future date. Interest receivable is also owed to a company.
Documenting interest receivables in your balance sheet can help you determine the amount of money (in interest) owed to your company.
The interest receivable is often considered a current asset unless the company is not expecting the payment in a year.
3. Trade Receivable
Trade receivable is the amount of money a customer owes a business for the purchase of goods and services. It includes both notes receivable and accounts receivable.
The opposite of trade receivable is accounts payable (which is the money a company owes its suppliers). You can calculate the total amount of trade receivable by adding up the amount of sales customers receive on credit.
Trade receivables are usually recorded as a current asset in a company's financial statement.
4. Non-trade Receivable
Non-trade receivable refers to the amount owed to a company not related to business transactions. It refers to money that is not gotten from the purchase of a product or offer of services. Non-trade receivables can be from dividends, advances to employees, claims for losses, or interest receivable.
For instance, if a company lends one of its employees some money for a personal travel advance, it will be recorded under the non-trade receivable because it is not related to the purchase of goods and services.
Non-trade receivables can be a current asset or long-term asset depending on the payback time of the borrower.
Accounts Receivable FAQ
Accounts receivable is simply the amount owed to a business due to the purchase of goods and services on credit.
Most businesses send an invoice to customers indicating the amount of money to be paid and the deadline to make the payment. The customers are expected to make payments within the agreed time frame. This relieves the customers of the stress of getting loans to pay for goods bought from companies.
Some businesses offer this opportunity to only special customers while some others offer the opportunity to all their customers. For instance, when an electricity company issues invoices to its customers after supplying them electricity, it is recorded as accounts receivable in the company's account.
Since accounts receivable represents the money owed to a business, when it is paid, it adds to the company's cash asset.
Accounts receivable are recorded as an asset in a company's balance sheet because it provides value to a company. It is always recorded as a current asset because it is usually converted to cash within a year. However, in specific cases where it is converted after a year, then it is a long-term asset.
Accounts receivable generally have a debit balance but can also have a credit balance in some situations.
Technically, accounts receivable is a debit until the customer makes payments as indicated in the invoice. Once the customer pays, the accounts receivable will be credited meaning that the customer no longer owes you.
When you are certain that your client is not going to pay the invoice you send, then you have to disregard it as a bad debt expense. In other words, your account receivable will not get paid.
For instance, let's assume after a few months of waiting for the hotel your furniture company supplied cozy sofas to pay up the invoice, they did not pay up. You even tried to reach out to the hotel, and still no positive result. Then it is clear that the hotel is not going to pay the money for the goods they ordered.
What you have to do is to debit the ‘allowance for uncollectible accounts' account. Debit whatever amount the hotel is meant to pay from the uncollectible account. This is because the ‘allowance for uncollectible accounts' account is a miscellaneous estimate of how much you might not get from your customers.
After debiting the uncollectible accounts, you would credit the accounts receivable that same amount. You need to do this to balance your books.
Most businesses calculate their accounts receivable so that they can know how much outstanding payment needs to be made. Businesses calculate accounts receivable either monthly, every quarter of a year, every half year, or annually.
Calculating accounts receivable can help you monitor your credit sales to know whose payment is due so you can take the necessary steps. You can use accounting software tools and invoice generators such as QuickBooks, Xero, Zoho, and other QuickBooks alternatives to automatically calculate your accounts receivable.
To calculate accounts receivable, you can simply add up all the amounts of the product and services your company offered on credit. It will represent the money your customers owe you for the products you have delivered. You can also add up the amounts on the company's copy of the unpaid invoices to get the accounts receivable.
You need to first know the average accounts receivable before you can calculate the turnover ratio. To get the average account receivable, divide the accounts receivable amounts by the number of items you sold. Then calculate the net credit sales by subtracting the sales allowances and sales returns from the credit sales.
You will get the account receivable turnover ratio by dividing the net credit sales by average accounts receivable. The turnover ratio shows how effective you are in collecting the money customers owe your business from credit sales.
Here is the formula for the accounts receivable turnover ratio.
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Average Accounts Receivable = Account Receivable Amount / Number of Items Sold
Net Credit Sales = Credit Sales – Sales Allowances and Sales Returns
The account receivable (AR) aging schedule is used to track different customers on the payment of unpaid invoices. You can draft a schedule from the calculation of AR aging.
The formula for calculating is:
Aging of Accounts Receivable = (Average Accounts Receivable * 365 days) / Credit Sales.
Generally, the number of days in a year is 365 days but some companies use 360 days to avoid fractionated answers. The choice of the number of days to use is a personal decision.
For example, Rowland Jr Electronics has accounts receivable worth $600,000 on the 4th of January, 2016. On the 31st of December, 2016, he has accounts receivable worth $400,000.
During that period, he sold goods worth $1 million on credit. What is the accounts receivable aging?
To calculate the accounts receivable aging, you first have to get the average accounts receivable.
Average Accounts Receivable = $600,000 + $400,000 / 2
Average Accounts Receivable = $1,000,000 / 2
Average Accounts Receivable = $500,000
The formula for aging of accounts receivable is:
Aging of Accounts Receivable = (Average Accounts Receivable * 365 days) / Credit Sales.
Aging of Accounts Receivable = ($500,000 * 360) / $1,000,000
Aging of Accounts Receivable = 180 days
If you calculate this data efficiently, it will be easy to keep track of customers that have not fulfilled their payments.
Tracking different customers for making late payments for credit purchases can be cumbersome and time-consuming. Preventing this will save you some stress. Here is what you can do to save yourself some stress.
Set Up A Clear and Disciplined Policy. You may be tempted to bend the rules and extend the payment time frame for customers. It is a trap; extending payment time causes more problems than it solves. One of such problems includes massive strains on your company's finances. To avoid this, develop a strict, but comfortable policy that guides the payment for goods bought on credit.
Follow this policy unbiased even if it means cutting ties with some customers. When acquiring new customers, including the policy in the agreement form for them to understand how your business operates.
Offer Your Customers Financial Incentives. Another way to hasten your client's payment is by offering them incentives like discounts. Offer them discounts for making early payments. Give them the timeframe for which a discounted offer is available. It will encourage them to pay faster because of the slight decrease in the size of payments.
Check On Them and Send Regular Reminders. After credit sales, ensure you regularly send reminders to your customers. Reach out to them using the customer service line. Sending reminders at regular intervals can keep your customers' memory glued to the money they owe you.
Sometimes, talking to them on the phone can compel them to make payments faster than they planned to.
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