Understanding Accounts Receivable (AR)

Accounts Receivable (AR) is the amount of money your clients owe you for goods or services delivered but has not been paid yet. Good knowledge of accounts receivable enables a business owner to improve the cash flow, manage capital on financial opportunities, and sustain flexibility.

What is the Meaning of Accounts Receivable?

Accounts receivable is the payment which a business will receive from its customers who purchased its services on credit. The term receivable refers to a premium not yet realised. Most companies sell their goods and services and extend a credit line to their customers. Depending on the agreement, the credit period can be from a few days to a year.

Moreover, business owners should keep in mind that the longer they do not collect the due amount, the longer they will face limits to financing production in their next order. Late or uncollected payments will impact the company’s working capital. This is why an accounts receivable process must be in place to easily determine overdue payments.

Accounts Receivable Process

The process of accounts receivable differs for large and small entities. Larger firms have a higher cash inflow. Hence, they invest in highly skilled credit teams and IT systems for a more efficient AR process. This section discusses the basic steps in a typical AR process.

Developing a credit application process

The company decides whether it will offer goods on credit based on the credit status of the applicant. It should also establish terms and conditions that outline the individual’s obligations and requirements. The document should include the interest rates for the credit owed.

Issuing invoice

An invoice is generated when a business extends credit to a customer. It has a unique number for easy retrieval. Additionally, this document is provided to the buyer and should contain the following details:

Goods and services provided
Individual and total costs of goods and services rendered
Date when payment is expected

Tracking accounts receivable

An AR officer is responsible for tracking the accounts receivable. The sales are fed into the system to ensure that all payments are accounted for and are duly posted. This step also includes sending monthly statements to clients.

Accounting AR

The payment due date is established by a collections officer. Their department makes entries in the accounts receivable journal. It involves accounting for unpaid debts, bad debts, and early payment discounts.

Example of Accounts Receivable

The most common example of accounts receivable is the billing practice of utility companies. An energy or water company usually bills their customers after usage. While the company awaits payment, the unpaid invoices are listed in the accounts receivable.

Most companies allow a portion of their sales to be on credit. This is usually offered to frequent or special customers that receive periodic invoices. It helps customers avoid the hassle of making payments per transaction.

Accounts receivable vs accounts payable

Accounts payable (AP) is the amount your company owes a third party for using their services on credit. On the other hand, accounts receivable (AR) is the amount your company has the right to collect for services rendered to clients on credit.

Frequently asked questions

What is the formula for accounts receivable?

An AR formula does not exist because it is based on purchases and credits. What matters is the formula for calculating the AR turnover ratio. It gives the owner an idea of how the company is managing its assets and revenue. The formula for calculating the turnover ratio is:

Net Credit Sales / Average AR = AR Turnover Ratio

What type of account are accounts receivable?

AR is recorded by an accountant or business owner as a current asset. It means that the customer will pay the balance within 12 months or less. If the AR is not set within 12 months, it will be listed on the balance sheet as a long-term asset.