What Is Accounts Receivable and How Does It Function?
By Indeed Editorial Team
Updated 27 September 2022
Published 8 September 2021
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Companies big and small may use accounts receivable (AR) when conducting important financial recordings. Through this procedure, they can better manage any outstanding payments that customers and clients owe to them. Becoming more familiar with AR can help you better use it within your own accounting processes, so you're able to track and retrieve your overdue payments more efficiently. In this article, we answer the question "what is accounts receivable?", explore the AR process, examine how businesses use it, review whether it's debit or credit and examine an example of accounts receivable.
What is accounts receivable?
To understand what is accounts receivable specifically, it's the process of obtaining payment for services or goods. It may also refer to the department in charge of billing. In accounting, the term “receivables” means that a business has made a sale, but hasn't yet received the proceeds from that sale. A lot of companies allow their customers to buy items within their inventory on credit. These credited items fall under the AR general heading. For example, utility companies only bill you after the period that you used their supply. All unpaid invoices sent to customers would qualify as accounts receivable.
The extension of credit to its customers by a business sets up the existence of an account receivable. AR can constitute a lot of a company's assets that haven't yet materialised. It usually comes due within a year or less from the time that the client initiates the purchase. One way to think of an AR is it's an amount the customer owes the business. The customer has a certain amount of time to pay off the balance on the account. Failure to do so can result in default.
Related: How To Become a Freelance Accountant
What is the typical process for accounts receivable?
A typical AR process helps businesses determine any accounts that are due soon, including ones that are already overdue or that the company has collected successfully. The primary goal for using this methodology is to make sure that the collection of receivables is easy to manage and track. The process that companies use may differ depending on the scope of their cash flow. Larger companies might use credit management and accounting teams, while smaller companies can simply use an internal advisor or analyst. Aside from these slight differences, consider the following four important steps in the AR process:
1. Developing credit practices
By analysing a particular client, the business may decide whether they're interested in offering them a line of credit. They may prepare a document that outlines the terms and conditions for sale on credit. The company may include within the document full disclosure for credit practices. A lawyer may ensure that the document and agreement conform to all applicable laws. Terms and conditions often vary with the scale of the business as well.
Larger firms offer longer periods for customers to repay their debt. Because of restricted cash flow from smaller firms, they tend to want to close their accounts receivable in a limited window and thus offer shorter payment periods.
2. Completing invoicing
The business would then create an invoice for the customer. The invoice is a document that gives the customer a rundown on the items they have purchased, the individual costs of each item and the expected time for payment. Invoices usually have a unique number that the company can use for referencing or retrieval.
While in the past, most invoices were physical, today's consumers have the option of a physical invoice or to go paperless with an e-invoice. Businesses may seek to send invoices out as soon as the buyer enters into a purchase agreement with them. The longer a customer takes to get an invoice, the longer they take to pay it.
3. Tracking AR
The role of tracking the receivables from these credit payments falls to the accounts receivables officer. The AR officer enters the values for the purchase, updates the ledgers and generates the invoice for the purchase. Additionally, with each payment, the AR officer updates the ledger to reflect the new amount the client has to pay. Smaller companies tend to use professional accountants to operate their AR processes. They may not have enough funds to hire an AR officer as a separate position.
Larger companies sometimes have entire credit management facilities with AR officers assigned to areas as opposed to individual clients. Additionally, larger companies can leverage sophisticated software and process automation.
4. Accounting for AR
The company's collections officer defines the due date for payments. Once the business manages to identify unpaid debts, the accounting department goes ahead and records the sales. The reconciliation of accounts includes accounting for unpaid debts, bad debts and early-payment customers.
Ways that businesses use accounts receivable
Businesses use accounts receivable to manage the accounts of their clients because it's flexible. There are circumstances when a business sells an item to a customer that cannot readily pay for the item in a single transaction. As such, accounts receivable would allow the company to track that incomplete transaction until it's completely paid off. Here are some other uses for accounts receivable:
Interest payment plan
One way that a business might use accounts receivable is for a payment plan process. Some businesses offer their customers the option to pay for a service or item over an extended period of time, usually in smaller amounts for each pay period. However, by opting in to this feature, customers may usually pay more because they incur interest in their accounts. Buying goods on a payment plan is attractive to customers that have a monthly budget to operate and uphold.
While a business can provide this method of payment because it closes the sale, it's important to be mindful of the potential risks. If a customer does not make their payments or consistently pays late, then they often go through additional steps to retrieve their overdue payments from customers.
Supply agreements and contracts
Some businesses have customers that regularly make purchases from them over a specific period of time or at certain intervals. As such, a supply agreement enables them to manage the AR for these recurring business payment accounts. For example, a luxury clothing boutique buys clothes from a clothing manufacturer weekly up to a specific amount. The clothing manufacturer may maintain accounts receivable for the luxury clothing boutique in their financial records to ensure that the boutique is making their payments every month as agreed upon in the supply contract.
Related: What Is a Supply Chain Manager?
Measurement of company reputation and liquidity
Accounts receivable is an important part of a company's ability to measure its liquidity. Most valuators review a company's AR history to assess how many short-term assets the company can commit to stock acquisition or infrastructure with no negative impact. When an accountant performs a critical analysis on a business, they often look to see how a business manages to collect payments and close out their AR balances promptly.
This unique relationship is what you can refer to as the accounts receivable turnover ratio. The more often a company can collect overdue payments and close their AR accounts successfully, the stronger their business credibility and reputation become. Therefore, it becomes essential that these companies implement collection practices to ensure they maintain their business operations and legitimacy.
What is the difference between accounts receivable vs. payable?
The primary difference between receivables and payables is what they represent. Accounts receivables are assets, referring to the money a customer owes you. Accounts payable are liabilities, which refers to the money you owe a client. And you would record them as their respective terms on a financial statement or balance sheet. The location where you record these two payment claims is also different. Because accounts receivables are assets, you may list them under the asset section. With payables being liabilities, you list them under the liabilities section.
Is accounts receivable a debit or credit?
In accounting, accounts receivables are debits. The term debit refers to payments that a customer has to pay to a company for a product or service. You can find the monetary value of this good listed on the company's balance sheet under assets. You debit a balance sheet because of the accounts receivables that a client owes. If a company had to pay a supplier for a product or service, then you would credit the balance sheet for current liabilities.
Example of accounts receivable
The following is an example of accounts receivable, how it works, and how you record it:
Bishan Technology is an upscale technology company that sells luxury electronic devices. Their products are expensive, so they offer an optional three-month payment plan for customers who can't pay in one payment. However, one of their customers has an account that has surpassed the 30, 60 and 90-day period and they still have not made their 60-day payment. It's now been 120 days since they stopped making their payments. The customer should have paid $1500 in total, $500 for each pay period, but they've only paid $500.
In this example, $1000 is the AR amount owed to the company, and the accountant records it against the customer's account under assets.
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