Understanding Accounts Receivable (AR) for businesses with examples

by Dhanashree 10 min read

Published: May 8, 2023 ● Updated: Mar 21, 2024

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Accounts receivable (AR) is an asset on a company's balance sheet. It represents the total amount of money the company owes its customers, less any already paid amounts. In other words, accounts receivable is the money a company expects to receive in the future from its customers.

This guide will teach you everything you need to know about accounts receivable, including what it is, how to record it, and why it's essential.

What is accounts receivable?

Accounts receivable is a legal obligation that a customer owes to a company for products or services that have been delivered but not yet paid for. It is recorded on the company's balance sheet as an asset since it represents money the company owes and will eventually receive.

Simply put, accounts receivable are the money a company owes its customers. This can be in the form of invoices, bills, or other types of documentation.

Invoices are the most common type of accounts receivable. When a company provides goods or services to a customer, it will send an invoice to the customer detailing the amount owed. The customer has a certain period to pay the invoice, typically 30 days.

Once the invoice is paid, the accounts receivable is reduced by the payment amount. If the customer does not pay the invoice within the specified period, the accounts receivable is still recorded as an outstanding debt on the company's balance sheet.

Accounts Receivable Example

An example of accounts receivable would be if a writing company were hired to produce a report for a client. The writing company would then generate an invoice for the client detailing the amount owed. Once the job is complete and the product/service has been delivered, the client has a certain period to pay the invoice.

This amount will be marked as "accounts receivable" until the client pays the invoice. Once the payment is received, the accounts receivable will be recorded as "cash" or "revenue" on the company's financial statements. Different bookkeepers and accounting software programs may use different terms for accounts receivable, but the concept is always the same.

If a client does not pay an invoice within the specified time frame, the accounts receivable will become a "bad debt." This means the company will not likely receive payment and will have to write off the loss. Bad debts are also recorded on financial statements but reported separately from accounts receivable.

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Benefits of Accounts Receivable

Accounts receivable cycle is an important part of any business. They provide a source of working capital. This is because accounts receivable represent money owed to the company, which can be used to cover expenses and improve cash flow.

The benefit of accounts receivable is that they can be used to secure debt for the firm. Accounts receivable can be used as loan collateral, providing the company with much-needed capital.

A company can increase its chances of securing a loan by proving that legally-binding accounts receivable exist. This is because the creditor can see the proof of business success (in the form of accounts receivable) and the company's ability to repay the loan.

Another option to access capital would be to use accounts receivable financing in another way. Some companies may choose to sell their accounts receivable to a third party at a discount. The third party then becomes responsible for collecting payment from the client. This can be a good option for companies that are struggling to make ends meet, but it can also be very expensive.

Invoices can help businesses keep track of what was sold and manage their inventory by knowing when to order more products. This is because accounts receivable can be used to finance inventory, meaning businesses can order more stock without paying for it upfront. This can be a helpful way to manage cash flow and keep inventory levels high.

Thus, accounts receivable serves as both market research in the perspective that it can help businesses understand what is selling and when to order more products and a source of working capital.

In addition to the benefits of working capital, it can also improve sales. it enables clients and customers to buy now and pay later. Customers are more likely to purchase if they do not have to pay for it immediately. By offering the market the ability to test a product before purchase, accounts receivable also provide an opportunity for businesses to increase sales.

This can also be especially helpful for recurring and large, one-time purchases. For example, if a customer wants to buy a new car, they may be more likely to do so if they can finance the purchase and make monthly payments. The same is true for businesses that offer services, such as subscription-based businesses.

Finally, accounts receivable can help businesses manage their taxes. This is because accounts receivable can be used to offset income taxes. If an account receivable can't be paid back, the business can write it off as a bad debt, reducing the amount of taxes owed.

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Components of Accounts Receivable

Accounts receivable are an integral part of a company's financial statements. They are typically broken down into three main parts:

The Principal: This is the original amount owed by the customer.
The Interest: This is the amount of interest accrued on the receivable.
The Late Fees: This is the number of late fees charged to the customer.

These three components are important to understand, as they can affect a company's financial health. The principal is the most important part of accounts receivable, as it represents the money that is owed to the company. The interest and late fees are also important, as they can increase the amount of money owed to the company.

It is important to remember that accounts receivable are not always paid on time. Accounts receivable can often be one of a company's biggest sources of bad debt. This is why having a strong accounts receivable policy and a good accounts receivable management system is important.

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Accounts Receivable vs. Accounts Payable

Accounts receivable and accounts payable are two important concepts in the accounting cycle. Both represent money owed to a company, but there are some key differences between the two.

Accounts receivable can be the money owed to a company by its customers. In contrast, accounts payable is money that a company owes to its suppliers. The former represents an asset, while the latter represents a liability.

Although they are both debts, accounts receivable is generally considered more favorable than accounts payable. This is because accounts receivable represents money owed to the company, while accounts payable represent money that the company owes. In other words, accounts receivable brings in money, while accounts payable pay out money.

Outstanding accounts payable can lead to several accounting problems for a company. First, it can lead to cash flow problems, as the company may not have enough money to pay its suppliers. This can lead to suppliers cutting off the company, which can lead to production stoppages. Second, it can damage the company's credit score, as accounts payable are a form of debt. This can make it more difficult and expensive for the company to borrow money.

Finally, it can harm a business to the point of bankruptcy. This is because accounts payable are considered unsecured debt, which means that any collateral does not back them. If a company defaults on its accounts payable, its creditors can take legal action to collect the money owed. This can lead to the seizure of company assets, and in some cases, the company may be forced into bankruptcy.

Accounts receivable is a much more favorable position than accounts payable. Businesses that can ensure that their accounts payable will be made on time while maintaining a strong accounts receivable position will be in a much better financial position.

Why are accounts receivable important?

As a review, accounts receivable are important because they represent money that is owed to a company. This money can be used to finance the company's operations, and it can also be used to pay off debts. Accounts receivable can also be used as collateral for loans, which can help a company obtain financing.

Strategic tax-write-offs are another way accounts receivable can be used to a company's advantage. Accounts receivable can be used to offset income taxes owed, which can reduce a company's tax liability.

Accounts receivable can also be used as a source of cash in the event of an emergency. If a company needs to raise cash quickly, it can do so by selling its accounts receivable to a third party. This is known as factoring.

Overall, accounts receivable are important because they provide flexibility to a company regarding how it can use its money. This debt owed to the firm can sometimes serve as an emergency fund and can also be used to finance operations or pay off other debts.

How to Record Accounts Receivable?

There are generally two ways to record accounts receivable, the direct write-off method and the allowance method.

The direct write-off method records the accounts receivable as they are settled with the customer. This means that when you receive payment from the customer, you will record it as accounts receivable. This is the simplest way to record accounts receivable, but tracking which accounts receivable have been paid and which ones are still outstanding can be difficult.

The allowance method is a more complex way of recording accounts receivable but can be more accurate. With the allowance method, you create an allowance account that tracks the expected amount of bad debt.

As payments are received, they are first applied to the accounts receivable balance. The account is written off as bad debt if payment is not received. This method requires more record keeping, but it can be more accurate in tracking which accounts receivable are still outstanding.

No matter which method you use to record accounts receivable, it is important to keep accurate records. This will help you track which accounts receivable are still outstanding and make it easier to collect customer payments.

How to automate accounts receivable?

There are many ways to automate accounts receivable. One way is to use software that can track customer payments and automatically apply them to the correct accounts receivable. This can help you keep accurate records and make it easier to collect payments.

Another way to automate accounts receivable is to use a service that will manage your accounts receivable for you. This can be a good option if you do not have the time or resources to track customer payments yourself. Many services offer this type of service, and they can be a good option for small businesses.

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Here's why you should consider Nanonets for AR automation.

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Conclusion

Accounts receivable is one of the most important aspects of any business. It's a measure of the creditworthiness of a company and its ability to pay its bills. It's also a good indicator of future sales and profitability. Understanding this concept will help you make better financial decisions for your business.

Accounts Receivable FAQs

Still, have questions about accounts receivable? Don't worry. This section will clearly and concisely answer some of the most common questions about accounts receivable.

Where do I find accounts receivable?

Accounts receivable can be found on a company's balance sheet.

Do accounts receivable count as revenue?

No, accounts receivable do not count as revenue. Revenue is the total amount of money a company has received in exchange for its goods or services. On the other hand, accounts receivable are defined as the money a company owes its customers for goods or services.

What is the "allowance for uncollectible accounts" account?

The allowance for uncollectible accounts is an estimation of the accounts receivable that will ultimately not be collected. This account is also known as the "bad debt" account.

What happens if my clients don’t pay?

If your clients don't pay, you will have to write off the accounts receivable as bad debt. This means you will no longer be able to collect the money you are owed. The accounts receivable will be removed from your balance sheet, and the bad debt will be recorded.

What if they end up paying me after all?

If a customer ends up paying you, you can remove the bad debt on the balance sheet. Since the payment is secured, it will become revenue as the debt owed to the firm is extinguished.

What is the accounts receivable turnover ratio?

The accounts receivable turnover ratio, also known as the receivables turnover ratio or the debtor's turnover ratio, is a financial ratio that measures a company's efficiency in collecting its accounts receivable. The accounts receivable turnover ratio is calculated by dividing a company's sales on credit by its average accounts receivable.

A high accounts receivable turnover ratio indicates that a company is effectively collecting its receivables and, therefore, is generating a lot of cash flow. A low accounts receivable turnover ratio, on the other hand, could indicate that a company is having difficulty collecting its receivables, which could lead to cash flow problems.

Those with low turnover ratios may benefit from enforcing stricter credit policies, such as requiring customers to provide a deposit upfront or lengthening the terms of credit. Outsourcing to a third-party accounts receivable management company is another option to consider.

What is an accounts receivable aging schedule?

An accounts receivable aging schedule is an report that lists a company's accounts receivable by the length of time they have been outstanding. The purpose of an accounts receivable aging schedule is to help a company keep track of its accounts receivable and to identify accounts that may be at risk of not being collected.

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