What is an Accounts Receivable?

Accounts Receivable

Accounts receivable (AR) represent the outstanding invoices or the money owed to a company by its customers for goods or services provided on credit. When a company sells its products or services to a customer and allows them to pay at a later date, the company creates an accounts receivable, which is recorded as an asset on the balance sheet.

Accounts receivable is an essential component of a company’s working capital management and cash flow, as it indicates the funds that the company expects to collect in the short term. Efficient management of accounts receivable is crucial to ensure that the company collects payments on time, maintains a healthy cash flow, and minimizes bad debts.

The accounts receivable process typically involves the following steps:

1. Extending credit: The company sets credit terms and conditions for customers, including credit limits and payment terms (e.g., net 30 days, which means payment is due within 30 days of the invoice date).
2. Issuing invoices: The company sends invoices to customers, detailing the goods or services provided, the amount due, and the payment terms.
3. Collecting payments: The company follows up with customers to ensure timely payment and may offer discounts or incentives for early payment.
4. Recording and tracking: The company records the accounts receivable transactions in its accounting system and regularly tracks the outstanding amounts and aging of receivables to manage collections and assess credit risk.

Accounts receivable aging reports are commonly used to monitor the outstanding receivables, categorizing them based on the length of time they have been outstanding (e.g., 0-30 days, 31-60 days, 61-90 days, and over 90 days). This helps companies identify overdue accounts and potential bad debts, allowing them to take appropriate actions, such as payment reminders, collections efforts, or adjustments to credit terms.

Example of an Accounts Receivable

Let’s consider a fictional company called “Tech Solutions,” which provides IT consulting services. Tech Solutions offers its services to clients on credit, with payment terms of net 30 days.

Here’s an example of accounts receivable for Tech Solutions:

1. Tech Solutions completes a project for a client, Client A, and the total invoice amount is $10,000.
2. Tech Solutions issues an invoice to Client A with a due date 30 days from the invoice date.
3. Client A now owes Tech Solutions $10,000, so this amount is recorded as accounts receivable on Tech Solutions’ balance sheet.
4. Tech Solutions regularly tracks the outstanding invoice and sends payment reminders to Client A as needed.
5. On day 25, Client A makes the payment of $10,000.
6. Tech Solutions records the payment, reducing the accounts receivable balance for Client A to zero.

Throughout this process, Tech Solutions manages its accounts receivable to ensure prompt payment, maintain a healthy cash flow, and minimize the risk of bad debts. By tracking and monitoring outstanding receivables, Tech Solutions can take appropriate actions to collect payments, adjust credit terms, or initiate collections efforts when necessary.