Accounts receivable is an accounting term that refers to sales for which payment has not yet been received. The customer has not paid for the good or service received at the time of the transaction. Instead, the business has extended credit to the customer and expects to receive payment for the transaction at some point in the future.
In contrast, for the customer who owes the payment, the transaction will be recorded as an account payable. The two are opposite representations of the same transaction. While the two parties to the transaction do not share accounting books, their entries should cancel each other out.
For example: an account receivable for business A (money to be paid) for a $100 product sold will equal an account payable (money owed) by business B for the same amount. When the payment has been made, the transaction will have zeroed out for both entities. Business A will have received its $100, and business B will no longer owe a $100 payment for the product it received.
Accounts receivable are an important accounting metric. They represent convertible assets owed to the company. That is, they describe a financial resource that can be converted to cash in the near future, once the customer has paid. Similarly, they are the basis for measuring the business’s ability to convert sales into cash. When payments are not collected for accounts receivable, this is an indicator that the business is not performing.
Accounts receivable are typically collected in two months or less. For this reason, they are considered a “short-term asset” which refers to any financial resource that can be converted to cash in one year or less.
A business that extends credit to customers is demonstrating trust and extending goodwill. This can help the business expand its customer base, which will generate more revenue. On the other hand, some customers may not pay. This creates bad debt for the business. In this way, accounts receivable are like investments. They come with rewards as well as risks.
The first step in recording accounts receivable is the invoice. The invoice is a document produced by the business to record the details of a transaction. The information contained in the invoice is vital to both the business and the customer. It will contain all of the vital information related to the transaction, including:
The name of the entity or unit providing the good or service
The recipient of the good or service
Detail about the good or service provided
The date on which it was provided
The quantity or amount that was provided
The value of the resource that was exchanged
As it relates to accounts receivable, an invoice will also contain important details about the terms of payment for the transaction. Once the invoice has been generated, the business should track it to determine if the customer has fulfilled the obligation for payment.
Based on the invoice, the transaction will be entered into the business’s accounting books. Typically, accounts receivable transactions will be entered into a subsidiary ledger (subledger) of the general ledger. All transactions in the subledger will be aggregated into what is called a control account.
A control account is a summary-level account in the general ledger. This account contains aggregated totals for transactions that are individually stored in subsidiary-level ledger accounts. Control accounts keep the general ledger from being cluttered with too much detail.
As a journal entry, individual transactions representing accounts receivable will be recorded as an asset on the debit side of the ledger and as revenue on the credit side. When payment is received, the transaction will be recorded as a credit to the account receivable asset and as a debit to the cash account. The accounts receivable account will cancel out to zero, and the transaction will appear as revenue in the form of cash.
Accounts receivable are used to measure the performance of the business in a number of ways. The receivables-to-sales ratio measures the accounts receivable in proportion to its sales for a given period of time. A high number shows that a greater number of sales are generating accounts receivable, as opposed to cash. This reveals a higher level of risk in the customer base and is not a good sign for the business.
The receivables turnover ratio is the inverse of the receivables-to-sales ratio. It measures sales as a proportion of accounts receivable.
In contrast, a higher number reveals a better success rate in collecting payment accounts receivable, which is a positive sign for the business.
Lastly, the days-sales-outstandingis calculated as the average number of accounts receivables divided by sales then multiplied by 365. This ratio shows how long it takes a company to convert its receivables into cash.
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