What is Accounts Receivable?

Definition: Accounts receivable, often abbreviated A/R, is the amount of money that customers currently owe to the company for goods or services that were purchased on credit.

Many companies offer credit programs to customers who frequent the business or suppliers who regularly order products. The purpose of credit program is to encourage customers to shop and give them incentives to purchase goods even if they donít currently have cash to pay for them.

We see these programs in just about every industry both B2C and B2B. For instance, the retail industry is famous for offering store credit with special credit cards where customers can purchase merchandise from the store and pay for it at the end of the month. Most department stores like JCPenny and Macyís have their own credit cards, but smaller retailers are also starting to develop these programs as well.

B2B examples include any manufacturer that orders parts from another without having to pay immediately. The seller packages up the parts and ships them to the buyer with an invoice directing the buyer to pay within 90 days. This is a less sophisticated account receivable example than the retail consumer credit card, but it works the same way. The purchaser has 90 days to pay for the goods that it ordered and received.

What Does Accounts Receivable Mean?

What is the definition of accounts receivable? The important thing to notice is that the accounts receivable definition doesnít limit itself to any type of business and customer. A/R simple consists of short-term debts that customers owe the business for purchases made on credit. The terms, due dates, and credit limits vary among businesses and industries.

Typically customer credit limits are set and approved by the sellerís credit department depending on the creditworthiness of the customer. Companies have to be careful before granting credit to customers that they donít know or have experience with since these customers can default of the debt and never pay for the product they purchased. Often times credit limits fluctuate with the economy. During a recession, a business might be less willing to extend credit. The opposite is true with regard to economic upswings.

Letís look at how accounts receivable is recorded and reported on the financial statements.

Bookkeeping Example

Like all standard asset accounts, the AR account has a debit balance. Companies record AR journal entries when a credit sale is made, a customer pays off his balance, or a bad debt is written off.

Thus, in order to record an accounts receivable journal entry for a sale to a customer, we would debit AR and credit sales. At the end of the year, the AR T-account is added up and transferred to the financial statements.

Financial Statement Presentation Example

Since, receivables are highly liquid assets that are expected to be converted into cash with one year, they are reported in the current assets section of the balance sheet at the end of each period.

Itís common for companies to report AR along with an allowance account for receivables that management doesnít think will be collected. The allowance for doubtful accounts has a negative balance that decreases the outstanding AR balance. This contra asset reduces the balance in AR similar to how accumulated depreciation reduces fixed assetsí carrying value.

A/R Management Example

Management uses the allowance for doubtful accounts to define accounts receivable that will likely not be collected and actively manage the ones that will. At the end of each period, management must evaluate the list of customers and balances on the accounts receivable aging report to identify which ones are past due and unlikely to be collected. Generally, the older and more overdue a receivable becomes, the less likely it will ever be collected.

Once these balances are identified, a journal entry is made to either increase the allowance or move the uncollectible accounts from the allowance account to an uncollectible or bad debt expense account on the income statement.

This process is important for several reasons. Uncollectible AR is not an asset because it will never be collected. If an uncollectible account is reported as AR, current assets will be overstated. Since many creditors use AR as collateral and calculate liquidity ratios on the value of current assets, itís important that these number reflect reality, so creditors arenít mislead as to the true liquidity of the business.

Aside from creditors, itís a good practice for management to regularly evaluate the aging accounts receivable report to make sure current customers are paying their bills on time, bad customers donít get approved for additional credit, and new customers are adequately vetted before being approved for credit.

Summary Definition

What are account receivables? Receivables are debts owed by customers to a company for purchased services or products on credit. A/R is recorded as an asset on the balance sheet until they are collected or written off.