Accounts Receivable – What is it?

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If you are a small business, you may make sales on credit. When you sell something on credit, you provide the good or service immediately and send an invoice to the customer to get paid later. The account where you track this information of who owes you and how much they owe is called accounts receivable.

It is very important to keep your accounts receivable up to date and accurate. We will go over why this is important and other relevant information about your accounts receivable in this article.

Accounts Receivable – An accrual-basis account

The Accounts Receivable (AR) account is where you track money that is owed to you. This means if your business follows the cash-basis accounting method, you will not have an accounts receivable, as you would be recording the transaction only once the money is received. With accrual-basis accounting, you record the transaction as soon as it occurs, so if the customer pays on credit, you will record it into your accounts receivable ledger.

Where is the Accounts Receivable account located in the books?

Accounts Receivable is an asset account, so it is located on your balance sheet or general ledger under the current assets section. This account is considered an asset account because the money is due to you, and is looked at as a future cash payment.

The balance sheet and general ledger will show you the total balance of the account, but to see specific information, you must look at the accounts receivable ledger.

Accounts Receivable vs Accounts Payable

As accounts receivable tracks the money you are due to receive, the accounts payable account tracks the money you are due to pay out. This means accounts payable is a liability account. Accounts Payable is listed on your balance sheet under current liabilities since the money is not considered yours as it will be used to pay whoever you owe soon.

Let’s look at an example

Imagine you own a small business that sells customized t-shirts. A customer has approached you looking to buy some of your shirts. They are also a small business owner. They own a small food truck and want to make matching shirts for their employees with a customized design on them.

You offer to make the five shirts with the custom design for $200. You make and send the shirts to the food truck owner and send an invoice for the $200.

You will record the $200 in your accounts receivable, as you soon will receive those funds. The food truck owner will record the $200 in their books in their accounts payable since they will be paying that money due to you soon.

Is the money recorded in accounts receivable the same as revenue?

Not technically, as the accounts receivable is an asset account, not a revenue account. But keep in mind, with accrual accounting, you are using double-entry bookkeeping. When you enter the amount into the AR account, you are also posting an entry in the revenue (or sales) account.

Sticking with our example above of your custom t-shirt business selling to the food truck owner, let’s look at our journal entries for the transaction.

Account Debit Credit
Accounts Receivable – Food Truck $200  
Revenue   $200

Since we are using accrual accounting, that means we are using the double-entry bookkeeping method. Every transaction will have two entries, a debit and a credit.

If you use cash-basis accounting, you will most likely use the single-entry bookkeeping method and you would not use the accounts receivable or the accounts payable accounts. You would only record the sale once cash exchanged hands.

What if you believe the customer will not pay the debt owed to you?

If you start to believe the amount the customer owes you will not be paid, you may need to move it to a separate account, so you don’t consider it when making decisions based on your AR balance. The account typically used in this situation is the Allowance for Doubtful Accounts. The allowance for doubtful accounts is a contra account. This means it is an account specifically used to reduce the value of another account.

If you have been a business owner for a significant amount of time, you can probably estimate the portion of your accounts receivable that will likely be uncollected by the year’s end. This method keeps you from having an accounts receivable amount on your financial statements that is overstated. If you already know that typically your business is unable to collect on 4% of your accounts receivable every year, you can set that estimated amount in the allowance for doubtful accounts, so you don’t make decisions on an overstated AR account.

When entering the journal entry for the allowance for doubtful accounts account, we also need to enter a second entry in the bad debt expense account. Going back to our example, let’s assume you have been in the t-shirt business for a while. You know based on your financial records that you typically see $30,000 in sales per year. You also know that on average 1 % of sales are uncollected, meaning the customer never pays. You would start the financial year with $300 (30,000 x 1%) in the allowance for doubtful accounts ledger and $300 in the bad debt expense ledger.

Account Debit Credit
Bad Debt Expense $300  
Allowance for Doubtful Accounts   $300

This placeholder is simply used to allow for a realistic amount to be shown in the AR account.

What happens when your assumption that they will not pay turns into them actually not paying?

Once you have concluded that a customer is not going to pay, you must write it off as a bad debt expense. Your journal entries will lower your allowance for doubtful accounts account and lower your AR account. This is because you no longer look at it as a cash payment coming, and part of your allowance for doubtful accounts has to be shown as being used, lowering the amount left in the account.

Account Debit Credit
Allowance for Doubtful Accounts $200  
Accounts Receivable – Food Truck   $200

Remember, the amount in doubtful accounts was just an estimation, so this actual bad debt would only leave an estimated $100 left in the account.

What if they pay the debt after you wrote it off?

If you concluded that an account was uncollectable, then down the line the customer actually comes back and pays what is owed, how would you show this in your books?

First, let’s reverse the journal entries made when the debt was written off.

Account Debit Credit
Accounts Receivable – Food Truck $200  
Allowance for Doubtful Accounts   $200

Next, let’s move the amount from the AR account into the cash account, as now it is in your hands and available to use.

Account Debit Credit
Cash $200  
Accounts Receivable – Food Truck   $200

At this point, your allowance for doubtful accounts is not showing the bad debt, your AR account has been cleared out for this transaction, and the sale is shown in your cash account.

Why is the accounts receivable account so important?

Very simply put, if you do not know who owes you money or how much they owe, your chances of collecting that debt are minimal. Using your AR account, you can be sure you are actively seeking payment from those who owe you.

If you rely on all customers to pay without any reminder from your end, you may find yourself with a lack of cash, which could put you out of business. Having accurate and up-to-date records gives you the information you need to help avoid any cash-flow problems due to bad debts.

What else can the accounts receivable account tell you?

Knowing how much each customer owes you is important, but the AR account also shows you some other information, like your turnover ratio. Your turnover ratio is used to illustrate how long on average it takes to collect a debt from a customer.

To calculate the turnover ratio for the AR account, you divide your net sales for the year by the average AR amount. To get the average AR amount, add the beginning balance on January 1st with the balance of the account on December 31st of the same year and divide it by two.

Let’s look at an example of the turnover ratio calculation.

Let’s say our t-shirt store made $28,500 in net sales in 2021. On January 1st, 2021, the AR account had a balance of $650 and on December 31st, 2021, the balance was $500.

First, we will calculate the average AR amount:

Average AR amount = (beginning balance + ending balance) / 2
= (650 + 500) / 2
Average AR amount = 575

Next, we can calculate the turnover ratio.

Turnover ratio = (net sales) / (Average AR amount)
= 28,500 / 575
Turnover ratio = 50

A higher turnover ratio signifies that your customers pay you quickly. Let’s turn this into the average sales credit period.

Average sales credit period = (number of weeks in a year) / (turnover ratio)
= 52 / 50
Average sales credit period = 1.04 weeks

This means, in this example, it takes a customer about a week to pay their debt to you. That is a great turnaround!

Is there any way to increase my turnover ratio?

There are several ways you can get your customers to pay you quicker.

  • Make your policy clear and stick to it. For example, if your policy is to not extend credit to a customer if they already owe a certain amount, stick to that policy.
  • Offer multiple payment options. If you only accept one form of payment, it may be inconvenient for your customer to pay, causing a delay in payment.
  • Offer a discount. Give your customer a reason to pay! Maybe if they pay what they owe at least one week before the due date, they can get a discount of 2% off their bill.
  • Consider your late fees. If you do not have any penalties for the customer paying late, they will be less inclined to pay on time.
  • Be on top of reminders. Your Accounts Receivable account (or Aging Schedule) shows you who owes you money, call or email them reminders so they don’t forget or lose track of the information.
  • Consider hiring a collection agency. If your customers still are not paying, and you have already stuck to your policy and cut them off, it may be time for outside help. Keep in mind though, you don’t ever want to be paying more for the collection than the debt is worth. You have to know when to walk away.

Accounts Receivable Aging Schedule

An accounts receivable aging schedule is a table that outlines each customer’s amount due, separated by how late their payment is. This can be helpful if you have many customers that pay on credit.

Here is an example of an AR Aging Schedule:

Customer 1-30 dates late 30-60 days late 60+ days late Total amount due
Greg Jameson 0 200 0 200
Betsy Smith 80 120 0 200

Looking quickly at this schedule, you can see Greg Jameson is over a month late on payment and Betsy Smith owes an amount that is over a month late and an amount that is less than a month late.

Using this schedule, you can decide what to do. Maybe you will hold off on any further transactions with Betsy Smith until they are caught up on past payments due, or maybe you decide to call Greg Jameson to see what the delay is on their payment.

Bad Debt

As we mentioned above, once the process of collecting a debt approaches the actual debt amount, it is time to write it off. That means even the cost of your time needs to be taken into consideration. Once you decide the debt is not worth it, it is time to write it off.

Bad debt can be deducted from your gross income when determining the taxable income for your business at tax time.

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