Your Guide to Understanding Accounts Receivable

A lot of terms tend to get thrown around in business without a specific explanation, especially when talking about finances; net revenue, operating income, and Cost of Goods Sold (COGS), for example. As a modern accounting professional, you’re expected to recognize, understand and utilize these terms and concepts when the need arises, even if you don’t necessarily use them on a day-to-day basis. Similar to elementary mathematical equations, financial basics like these help establish a solid, broad foundation from which you can learn other, more complex accounting topics throughout your career.

We’ve already covered many of these basics in our blog, including income statements, balance sheets, the net income formula and straight line depreciation. Here, we’ll discuss another important factor in a company’s total financial picture, the accounts receivable.

When businesses make transactions with their customers, they usually operate on an ongoing line of credit. In almost all situations (except with direct cash payments), a business will exchange a good or service and send an invoice or receipt to be paid at a later date.¹

To help keep track of all of those pending payments, there’s a specific section in accounting books called the accounts receivable. Simply put, accounts receivable is any money that is owed to you for goods or services. These payments can come in a few days or in a few weeks, but the hope is that it will always eventually be paid in full by the person or organizations that owe it to you.

An example of this would be a writer who works on a website for a family friend. After tallying up her working time and multiplying by her hourly rate, the writer sends an invoice for $500 to the friend. While she waits, she marks that she has $500 in her accounts receivable.

Because of the rolling nature of the payments, accounts receivable is only recognized in accrual accounting. Accrual accounting is a method of accounting in which revenues and expenses are recorded when they are earned, regardless of when the money is actually received or paid (an alternative would be cash basis accounting, but we’ll stick with accrual accounting as it is more commonly used).² This way, you can account for a transaction that occurred a week ago but the customer has yet to send their payment, or they’ve chosen to pay in increments rather than all at once.

It can be easy to confuse these two terms, but it also can be easy to remember them because of their inverse relationship: accounts receivable is the money that others owe you, while accounts payable is the money that you owe to others.

Continuing with the example above, let’s say the writer needed to enlist a graphic designer to help with her website project. She agreed to pay the designer $300 for their work and is going to send out the check as soon as she receives the $500 from her family friend. Thus, she’ll mark $300 in her accounts payable to note what she must eventually pay the designer. Similarly, the family friend will have the $500 that they owe to the writer in their accounts payable as well.

It may be tempting to think of your accounts receivable the same as your sales figures, but in accrual accounting, it’s really an asset account and a part of your revenue. It’s considered an asset because the other party is legally obligated to pay it to you and it’s currently valuable, with most being paid in a year or less.

Taking the time for understanding accounts receivable is a good business practice because it will ensure you aren’t cheated out of anything you’re owed. It also is a great way to keep track of various vendors and business partners, as you’ll have a record of all ongoing transactions.

In an ideal world, every payment would come on time and in full from the people who promised it to you. However, there of course are situations in which payments come late, in installments or not at all. When someone doesn’t pay and you can’t collect your accounts receivable, it’s called a “bad debt”. High amounts of bad debt aren’t good for anyone, but they mostly reflect poorly on your customer base and their ability to withhold payment agreements.

To account for the inevitable bad debts, businesses will set up an “allowance for uncollectible accounts”. Basically, this is the amount or percentage of money they expect not to receive back within the given timeframe. This also helps to keep their accounts receivable from getting unrealistically high, because they know that they likely won’t receive that entire amount.

If you consistently have bad debts and have to create a high allowance for uncollectible accounts, you should reconsider the people and organizations with whom you do work. Not only does it signify their poor working relationships, but it also affects your net income and will have to be noted on your balance sheets.

Let’s say the writer mentioned above is always waiting on payments or ends up getting none at all from the family friend who contracted her. After several months, it would be wise for her to cease work with that friend and find a new client.

As it is a primarily financial endeavor, a business’s accounting team will record and compute the accounts receivable (among many other things). They likely won’t be the ones to follow up with clients or decide their payment schedule, but they’ll be able to determine what is owed at any given time and set a reasonable timeframe for it to be completed. Financial professionals can also help set up a credit policy, an accounts receivable aging schedule and even can calculate an appropriate discount for those who pay their invoices early.

As you can see, the seemingly endless list of financial terms and topics (accounts receivable, more specifically) are vital to the day-to-day operations of a business. Similarly, you can see how any mistakes or underperforming parts can derail both short and long-term success. That’s why businesses are diligent about finding and retaining staff who can keep all of their finances in check.

The increasing demand for highly technical accounting professionals has also changed the industry’s hiring criteria. The best way to get up to speed on modern accounting needs is by earning your online Master of Science in Accounting from Yeshiva University. With this universally-regarded degree, you can learn all of the basic and advanced accounting topics, uncover how technology has and will continue to change the industry, and learn how to apply yourself in a team of like-minded professionals.