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Accounts receivable (sometimes abbreviated AR) refers to money that is due to a business or organization in exchange for products or services that have been delivered, but the receiving customer has not yet paid for—it represents money owed to the company by their customers. When a company allows a customer to purchase their products or services on a credit-based system, these purchases are logged in accounts receivable.
Accounts receivable is accounted for as an asset account, because it represents funds that a company has legal claim to, even though it doesn’t currently possess them.
Outstanding invoices owed to a company by customers or clients are also counted in accounts receivable, essentially representing a line of credit that’s been given by the company to the customer. The timeline required for customers to make these payments is almost always within one year of the transaction taking place, which is why accounts receivable are considered current assets rather than long-term assets.
Though accounts receivable don’t technically represent capital or funds currently held by the company, they’re counted as assets because customers are legally obligated to pay them within the time period stipulated by the contract or agreement.
Accounts receivable also helps companies develop a clear picture of their financial health. When only accounting for currently held capital, businesses may miss out on the bigger picture by failing to recognize owed payments as part of their short-term assets. Calculating accounts receivable reveals more current assets that a company can count in their valuation and other assessments/analyses.
Accounts receivable are similar in their structure but opposites in terms of what they actually represent. While accounts receivable represents debts that are owed to a business, accounts payable represents debts owed by the company to supplier or other third parties.
Because accounts receivable are considered current assets (assets that will be liquidated within one year of the generation of a financial statement), they can be considered as tools for covering short-term debts and obligations and can be quickly translated into actual cash flow.
Any business that bills its customers or clients after goods or services have been delivered can be used as an example of accounts receivable. For example, many utilities companies must wait for customers to use their services for a given period before billing them out of necessity—meaning, they can’t charge a customer for service until they know how much of that service they’ve used and what they’re owed.
These utilities companies would then send bills to their customers detailing how much the customers owe, and because the customers are paying for services already delivered, those owed amounts are filed as accounts receivable. Once they’re paid, that specific customer's account remains open because a new term has begun, and their payment for the next period (usually a month) will begin.
Accounts receivable is located under the Current Assets section of a balance sheet. Because accounts receivable are those that can be expected to be paid within a year, they’re classified as assets because they add value to your company as a whole—even if it’s in the form of a payment that hasn’t actually transpired yet.
Accounts receivable is not counted as revenue under any form of accounting, though in some cases it may be recorded at the same time as revenue. In accrual accounting, for example, revenue and account receivable are recorded simultaneously as a debit in account receivable and as a credit in revenue.
In cash accounting, accounts receivable are not counted at all. That’s because in this accounting system, sales are not counted until a business actually has the money in-hand.
Aside from helping to clearly show a company’s cash flow situation, accounts receivable is also important as a tool for tracking which payments are owed and which are becoming dangerously late. Late payments are a top cause of cash flow problems in many companies, so having clear visibility on which customers aren’t paying is important for businesses so that they can calculate their accounts receivable turnover ratio and work to lower it.
Any business that operates long enough with accounts receivable will eventually encounter customers who cannot or will not pay. This results in ‘bad debt,’ or debt that a business can no longer expect to be paid. In order to account for this in their financial statements, some businesses will account for ‘allowance for uncollectible debts.’ This account is represented as a credit, while simultaneously debiting the ‘bad debt expense’ account by the same amount.
Once it becomes clear that a debt won’t be paid, the amount in accounts receivable would be zeroed out, because once a business decides that an invoice can’t be collected, the debt is considered cancelled.
One of the most important ways of analyzing a company’s accounts receivable benefits is through their accounts receivable turnover ratio. This ratio measures exactly how many times a company has actually collected funds towards its accounts receivable balance during a specific accounting term. Other analysis factors that are related to the accounts receivable turnover ratio include days sales outstanding (DSO) analysis, which is a form of measurement designed to calculate the average collection period for a firm’s accounts receivables balance. In other words, it measures how long a business can expect to wait on average for an owed balance to be paid.
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