Account receivable

What Is Account Receivable?

An account receivable (AR) represents money owed to a business by its customers for goods or services that have been delivered or provided but not yet paid for. It is a current asset on the balance sheet, reflecting the credit extended to customers in the normal course of business operations. The management and tracking of accounts receivable fall under the umbrella of working capital management, a key component of financial management. Effectively managing accounts receivable is crucial for a company's liquidity and overall financial health.

History and Origin

The concept of an account receivable is deeply intertwined with the evolution of credit and the practice of double-entry bookkeeping. Early forms of credit existed in ancient civilizations, but the systematic recording of outstanding debts and payments gained prominence with the development of sophisticated accounting methods. The modern double-entry bookkeeping system, which forms the bedrock of accounting today, can be traced back to the merchants and bankers in medieval Italy. While earlier simplified versions may have existed, Luca Pacioli, a Franciscan friar, is widely credited for codifying and publishing a detailed description of the double-entry system in his 1494 mathematics textbook, Summa de arithmetica, geometria, proportioni et proportionalità.¹⁵, ¹⁶, ¹⁷, ¹⁸ This seminal work helped standardize the recording of financial transactions, including those related to credit sales and the resulting accounts receivable.

Key Takeaways

• Accounts receivable represent money owed to a company for goods or services delivered on credit.
• They are classified as a current asset on the balance sheet, signifying their expected conversion to cash within one year.
• Effective management of accounts receivable is vital for a company's cash flow and operational efficiency.
• The aging schedule is a primary tool for monitoring accounts receivable, categorizing them by the length of time they have been outstanding.
• Uncollectible accounts, also known as bad debts, necessitate adjustments to accounts receivable and can impact a company's profitability.

Formula and Calculation

While there isn't a single "account receivable formula" in the traditional sense, several ratios incorporate accounts receivable to evaluate a company's efficiency in collecting its debts. One of the most common is the Accounts Receivable Turnover Ratio, which measures how many times a company collects its average accounts receivable balance during a period.

The formula is:

$\text{Accounts Receivable Turnover Ratio} = \frac{\text{Net Credit Sales}}{\text{Average Accounts Receivable}}$

Where:

• Net Credit Sales are the total credit sales for the period, excluding cash sales. This figure is derived from the income statement.
• Average Accounts Receivable is calculated by taking the sum of beginning and ending accounts receivable balances for a period and dividing by two. This information is found on the balance sheet.

Another related calculation is the Days Sales Outstanding (DSO), which indicates the average number of days it takes for a company to collect its accounts receivable.

$\text{Days Sales Outstanding (DSO)} = \frac{\text{Average Accounts Receivable}}{\text{Net Credit Sales}} \times \text{Number of Days in Period}$

A shorter DSO generally indicates more efficient credit and collection policies.

Interpreting the Account Receivable

Interpreting accounts receivable involves assessing a company's ability to convert its sales into cash. A high accounts receivable balance relative to sales could indicate lenient credit policies, ineffective collection efforts, or a struggling customer base. Conversely, a very low accounts receivable balance might suggest overly strict credit terms that could deter potential customers.

Analysts often examine the accounts receivable aging schedule, which categorizes outstanding invoices by their due dates. This provides insight into the quality of the receivables and the potential for bad debts. For instance, a large proportion of long-overdue accounts signals a higher risk of non-collection. Comparing a company's accounts receivable trends with industry benchmarks and its historical performance is essential for a comprehensive evaluation. This analysis helps in understanding the efficiency of credit management and its impact on working capital.

Hypothetical Example

Consider "BrightBulb Innovations," a company that sells specialized lighting solutions to businesses. In October, BrightBulb completes a large installation for "GreenGrowth Landscaping" for $50,000, allowing GreenGrowth 30 days to pay. When BrightBulb records this sale, it debits its Accounts Receivable account by $50,000 and credits its Sales Revenue account by the same amount.

On November 15th, GreenGrowth Landscaping pays its invoice in full. BrightBulb Innovations then debits its Cash account by $50,000 and credits its Accounts Receivable account by $50,000. This transaction reduces the accounts receivable balance, demonstrating the conversion of a credit sale into cash. If GreenGrowth had only paid $30,000, BrightBulb's accounts receivable would still show an outstanding balance of $20,000. This example highlights how accounts receivable accurately reflect amounts due, playing a critical role in financial reporting.

Practical Applications

Accounts receivable are fundamental in various financial contexts:

• Credit Management: Businesses utilize accounts receivable data to establish and enforce credit policies, determining which customers receive credit and on what terms.
• Cash Flow Forecasting: Accurate forecasting of accounts receivable collections is crucial for managing a company's liquidity, helping to predict future cash inflows.
• Financial Statement Analysis: Investors and creditors scrutinize accounts receivable to gauge a company's operational efficiency and its ability to generate cash from sales. This forms a part of a broader financial analysis. The U.S. Securities and Exchange Commission (SEC) provides guidance on revenue recognition, which directly influences how and when accounts receivable are recorded on financial statements.¹⁰, ¹¹, ¹², ¹³, ¹⁴ This includes detailed rules under ASC Topic 606, which dictates when revenue may be recognized, impacting the corresponding accounts receivable.
• Working Capital Management: Accounts receivable are a significant component of working capital, and efficient management minimizes the need for external financing while maximizing returns.
• Taxation: Businesses may be able to deduct certain uncollectible accounts receivable as bad debts, as outlined by the Internal Revenue Service (IRS) in its publications concerning business expenses.⁵, ⁶, ⁷, ⁸, ⁹

Limitations and Criticisms

While essential, relying solely on the reported accounts receivable balance has limitations. The primary criticism revolves around the risk of bad debts, where accounts become uncollectible due to customer bankruptcy, disputes, or other financial difficulties. Overly aggressive revenue recognition policies can inflate accounts receivable, presenting a misleading picture of a company's financial health. Additionally, prolonged economic downturns or disruptions to supply chains can significantly impact a company's ability to collect outstanding receivables, potentially leading to increased write-offs.¹, ², ³, ⁴

Furthermore, accounts receivable do not earn interest, making them a non-earning asset until collected. A high accounts receivable balance ties up capital that could otherwise be invested or used to reduce debt. Businesses must balance the benefits of offering credit terms to boost sales against the risks and costs associated with carrying accounts receivable, including collection expenses and the potential for write-offs.

Account Receivable vs. Notes Receivable

Both accounts receivable and notes receivable represent money owed to a business, but they differ primarily in their formality and the presence of a written promise to pay. An account receivable is an informal, non-written promise from a customer to pay for goods or services delivered on credit. These are typically short-term, current assets that are expected to be collected within a year. Notes receivable, on the other hand, are formal, written promises to pay a specific sum of money on a definite future date, often with interest. They are typically evidenced by a promissory note, which is a legally binding document. While accounts receivable arise from standard sales transactions, notes receivable often stem from larger or more extended credit arrangements, loans, or the conversion of an overdue account receivable into a more formal debt instrument. The presence of interest and a formal legal document distinguishes a note receivable from a standard account receivable.

FAQs

How do accounts receivable impact a company's cash flow?

Accounts receivable directly affect a company's cash flow because they represent money that has been earned but not yet received. A delay in collecting accounts receivable can lead to cash flow shortages, even if a company is profitable. Efficient collection ensures a steady inflow of cash, which is vital for meeting operational expenses and investing in growth opportunities.

What is the difference between accounts receivable and revenue?

Revenue is the total income generated from sales of goods or services before any expenses are deducted. Accounts receivable, conversely, are specifically the portion of that revenue that has been earned but not yet collected from customers. Not all revenue will initially become an account receivable; cash sales, for example, generate revenue immediately without creating an accounts receivable entry.

Why are accounts receivable considered an asset?

Accounts receivable are considered a current asset on a company's balance sheet because they represent a future economic benefit that the company expects to receive in cash. They are a claim against a customer for payment, and this claim has monetary value, thus classifying them as an asset.

What is an aging schedule for accounts receivable?

An aging schedule is a report that categorizes a company's accounts receivable based on how long an invoice has been outstanding. It typically breaks down receivables into time buckets, such as 1-30 days, 31-60 days, 61-90 days, and over 90 days. This schedule helps businesses identify overdue accounts and prioritize collection efforts, aiding in liquidity management.

How do businesses reduce the risk of uncollectible accounts receivable?

Businesses employ various strategies to mitigate the risk of uncollectible accounts receivable. These include implementing strict credit policies for new and existing customers, conducting thorough credit checks, offering early payment discounts, and engaging in proactive collection efforts for overdue accounts. Companies may also use factoring or accounts receivable financing to convert receivables into immediate cash, transferring the collection risk to a third party.