What Are Accounts Receivable?
An Accounts Receivable Definition for Business
Accounts receivable, or receivables, are moneys owed to a business in exchange for goods and/or services delivered but not yet paid for by the customer(s). Legally, an accounts receivable entry represents a debt owed to the business that is settled upon receiving payment from the customer.
How Are Accounts Receivables Created?
An account receivable is generated whenever a business extends credit to a customer by not requiring immediate payment.
Normally this is achieved by specifying payment terms on the customer invoice, such as:
- Payment within a period of days – 7, 10, 30, 60, 90-day terms are common (also known as Net 7, 10, 30, 60, 90)
- Discounts for earlier payment – for example, a 90-day payment term but a 5 percent discount for payment with 10 days (also known as 5/10 Net 90)
- Line of credit payment – allowing payments in regular intervals (such as monthly or quarterly) over a period of time
Most service businesses extend credit in this fashion as a convenience to their customers, particularly those that provide goods or services on a regular basis. For example, utility companies such as phone, cable, and electricity providers normally invoice their customers monthly after delivery of services and include payment terms on their invoices. On the other hand, businesses whose sales are paid immediately upon delivery of products or services do not have accounts receivable.
Example Credit Invoice (With Payment Terms):
|From: Acme Landscaping||Invoice#:||341523|
|15 Drury Ave.||Date:||05/05/2018|
|Bilby, CA 87979|
|To: Ms. Alana Pendergast|
|7890 Fallinghawk Way|
|Bilby, CA 87954|
|Mowing/Edging @ $40.00/Hr||1.5 hours||$60.00|
|Tree Pruning @ 40.00/Hr||3||$120.00|
|Payment Terms: To be paid within 30 days of Invoice Date|
|Late Payment Terms: 1.5% Interest/month charged on overdue accounts|
The Importance of Accounts Receivable in Accounting Statements
Accounts receivable is listed as a current asset on balance sheets, as receivables are expected to be turned into cash (paid) within a short time. As such, it is an important measure of the fiscal health of a business and one that is heavily scrutinized by prospective lenders or buyers.
Businesses that extend credit are depending on the goodwill of customers to make payment within the billing period but there is usually a small percentage of customers who either pay late or not at all. According to The Accounting Minute, the longer an invoice goes unpaid the lower the chances of collection:
- 26 percent of invoices 3 months old are uncollectable
- 70 percent of invoices 6 months old are uncollectable
- 90 percent of invoices 12 months old are uncollectable
Consequently, when assessing the value of accounts receivable the odds of less than 100 percent collection must be taken into consideration. An estimate of the amount that is unlikely to be collected is called an 'Allowance for Doubtful Accounts' and is typically entered on balance sheets as a deduction below the accounts receivable line item. On income statements, it is entered as an 'Uncollectable Accounts Expense'.
Collecting Accounts Receivable
The collection of accounts receivable is critical to cash flow and should be a top priority for any business. Unfortunately, following up on unpaid bills is frustrating and time-consuming and many small businesses do not have the resources to spend time dealing with delinquent accounts. There are, however, a number of ways to mitigate the odds of non-payment:
- Before extending credit to a new client, thoroughly check their credit references. If the client is a business if possible confer with other businesses or customers who may have had dealings with them.
- Establish a routine of reviewing delinquent accounts on a regular basis (or having your bookkeeper do so) and contacting the account holders regarding payment.
- Facilitate easy payment by, for example, accepting credit card information over the phone or payment via PayPal.
- Know your customer and when to allow leeway on late payment. A business customer may themselves be waiting for payment from a large account or may have seasonal fluctuations that affect their ability to pay at certain times of the year. Allowing a little extra time for payment is preferable to losing a good, long term customer.
- Don't spend excessive time chasing small amounts owed. If the value of the effort required exceeds the amount owed dump the client and move on.
- If all else fails and you decide to turn to a collection agency, be aware that you will not recover the full amount owed. Collection agencies generally charge a contingency fee of from 25 percent - 45 percent of the value of the outstanding account.
- If the customer appears to be struggling financially, try to work out a long term repayment schedule. In addition to eventual repayment, you stand to gain goodwill from the customer which may result in more business in the future.
- Be aware that if a delinquent customer decides to file for bankruptcy your odds of recovering the amounts owed is minimal.
For more information on collecting accounts receivable see: Ways to Make Sure Customers & Clients Pay What They Owe
Accounts Receivable Financing
Selling (Factoring) Accounts Receivable
In a factoring arrangement, accounts receivables are sold at a discount to a third party in exchange for immediate cash. The third party then becomes responsible for the collection of invoice payments from customers. In exchange for assuming the risk of non-payment, receivables are heavily discounted (20 percent is typical).
The main difference between financing and factoring is that financed invoices still belong to the company, whereas factored invoices are disposed assets.