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For many businesses that get paid through invoices or bills, accounts receivable is critical for understanding the overall financial health of your company.
What is accounts receivable?
What is accounts receivable?
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.
How to record accounts receivable.
How to record accounts receivable.
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:
| Debit | Accounts Receivable |
| Credit | Sales |
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:
| Debit | Cash |
| Credit | Accounts Receivable |
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:
| Debit | Bad Debt Expense |
| Credit | Accounts Receivable |
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:
| Debit | Bad Debt Expense |
| Credit | Allowance For Doubtful Accounts |
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:
| Debit | Allowance For Doubtful Accounts |
| Credit | Accounts Receivable |
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.
Accounts receivable and cash flow.
Accounts receivable and cash flow.
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.
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