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Next Read: Guide To Accounts Payable
For many businesses that get paid through invoices or bills, accounts receivable is critical for understanding the overall financial health of your company.
Accounts receivable is money owed to your company, typically because you sold a good or provided a service and are awaiting payment. If you don’t receive cash for your good or service at the point of sale, the amount is added to your accounts receivable account. Most commonly, accounts receivable occurs in the form of outstanding invoices or bills.
Most businesses have some form of accounts receivable, even if you operate as a sole proprietorship. You will become very familiar with accounts receivable, sometimes abbreviated as AR, if you are a freelancer who gets paid via invoices or if you sell goods on credit.
Accounts receivable is increased—that is, debited—whenever your business delivers goods or provides services on credit. This means that your business was not paid for the goods or services immediately upon sale, but will rather be paid for them at some point in the future. Depending on your business’ billing practices, you may submit an invoice to your client or customer for these sales.
The journal entry to credit a sale on credit is:
And then when your business receives payment for these goods or services, you decrease your accounts receivable balance.
Here is the journal entry to record a payment from your customer on an invoice you sent them:
Bad Debt Entries
Unfortunately, sometimes a customer will not make good on their obligation to pay you for your goods or services. The most straightforward way to account for these instances is to decrease your accounts receivable balance and increase an expense account called bad debt expense when you have confirmed that your customer will not be able to pay your invoice. Here is the journal entry:
This will cause your business’ net income on its profit and loss statement to decrease because bad debt expense is an expense account.
An alternative method of accounting for your business’ receivables that will never be collected is by keeping a running allowance for doubtful accounts on your balance sheet. This will require you to estimate, perhaps based on your company’s historical data, the percentage of your accounts receivable at any given time that will be uncollectible. Then, once you’ve come up with this estimate, you record the following journal entry:
When using this method, your company’s profit and loss statement is only affected by this estimate, not by the actual write-offs of uncollectible accounts, which are recorded with this entry:
By using this slightly more complicated method to handle uncollectible accounts, you can better estimate the actual future cash flow from sales on credit that your business can expect. This is possible because you’ve already estimated the amount that will eventually become uncollectible based on your historical knowledge of your business.
In a sense, your accounts receivable balance is a necessary evil. Of course, you’d rather have cash in the bank immediately whenever you deliver a good or service to a customer. However, most businesses expect to have some leeway in terms of paying you for goods or services—generally to the tune of 30, 60, or even 90 days. For this reason, many of your sales have to travel through accounts receivable before they ultimately become cash in the bank.
Remember, your business will thrive or decline based on its ability to manage its cash flow. So if your business sells most of its goods or services on credit, one of the most important things you can do as a business owner is to optimize your business’ collections. This fundamentally means converting to cash the unpaid invoices represented in your accounts receivable balance as quickly and consistently as possible.
And this process can only take off if you’ve implemented tight, detailed accounts receivable bookkeeping procedures. This will allow you to effectively review not only where your accounts receivable balance stands today, but also year-over-year trends and other key data points. In turn, this will enable you to make key business decisions to improve your business’ collections and cash flow.
In an accounts receivable situation, you don’t immediately possess the cash earned from goods sold or services performed. In a simplistic sense, accounts receivable amounts to an IOU.
Because of this, accounts receivable is actually an asset account, not revenue. It is considered a current asset because you expect that you will be paid within a year. As an asset, accounts receivable adds value to your company because it is money that will be inflowing to your business in the future.
The opposite of accounts receivable is accounts payable, which is a liability. This is money your company owes others, such as if you have invoices that you need to pay.
Of course, when you send a company an invoice because they purchased goods or services from your company on credit, your customer will likely record a debit to their accounts receivable balance for this amount.
In theory, whenever you record an increase or decrease to your accounts receivable account, your customer records a corresponding decrease or increase to their accounts payable account.
Accounts receivable is critical because it reveals how much money you should expect to earn in the future. If you are paid primarily through invoices, this figure is directly linked to your overall income.
One factor that you need to pay attention to is the age of your accounts receivable. Are you getting paid on schedule? Are your customers or clients waiting too long to pay invoices? You will commonly have to send reminders if your accounts receivable is getting too old. Lenders will look at how your accounts receivable age when making funding decisions.
Logan Allec is a CPA and owner of tax relief company Choice Tax Relief, which negotiates with the IRS and state revenue departments on behalf of business owners who have fallen behind on their individual, corporate, or payroll tax obligations. With over a decade of experience consulting with business owners about their tax issues, Logan has seen almost everything when it comes to tax negotiations with the IRS and state tax authorities. Prior to starting his own tax resolution practice, Logan was in a managerial capacity at a Big 4 professional services firm, handling tax issues for billion-dollar companies. In addition to running Choice Tax Relief, Logan also owns the personal finance blog Money Done Right, which educates thousands of readers a day about making, saving, and investing money. Logan also runs a YouTube channel on which he publishes weekly videos about what everyday Americans need to know about taxes and tax relief. He has been a licensed CPA since 2010 and holds a master's degree in business taxation from the University of Southern California. Logan lives in the Los Angeles area with his family. When he's not working, he enjoys playing basketball, taking his kids to Disneyland, and discovering new hot sauces to enjoy.
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