In this sections we will cover what is accounts receivable, we will go into the journal entries for A/R, and talk through some of the logic of Accounts Receivable. We say it over and over again, but Cash is King. A large number of businesses sell on credit. This means they don’t make the custom pay for the product or service when they receive it, but rather some time in the future. Typically, this will be around 30 days. You may see this when you get a bill in the mail for something, that business sold to you on credit and now they have an Account Receivable with your name on it!
What is Accounts Receivable
So, we learned above a bit about what is accounts receivable. We learned that effectively, it is money a business is due for goods or services provided without being paid (i.e. on credit). Non-finance / accounting people might not think of sales on credit quite like an accountant. People think about buying something and paying right away or selling something and being paid right away. However, in business, as mentioned above, most of the time goods and services are sold on credit. Meaning, if a business sells something it will give it to the customer (or ship it to the customer) and won’t expect to get paid for some period (often 30 days).
Accounts receivable is an asset account (current asset). It is an asset that sits on the balance sheet that represents something a business sold to a customer that that customer has an obligation to pay them for in the future.
An Accounts Receivable Example
A simple example would be if you had an ice cream business and you got a contract with Whole Foods where they were going to buy your ice cream and sell it in some of their local stores. When you enter into the agreement with Whole Foods, since they are a big company and your ice cream business is a start-up, Whole Foods will probably force you into the payment terms that are standard for them. In this instance, let’s assume they tell you they will pay you 30 days from shipment.
When the ice cream ships you will invoice them according to those terms, 30 days (these are usually called payment terms). As soon as you ship them the ice cream and create the invoice you have a sale, but you won’t receive cash for 30 days. This means you have an Accounts Receivable asset on your balance sheet. Let’s look at what the journal entry for this transaction would be…
Accounts Receivable Journal Entries
You would create the sale (credit sales) and the receivable (debit A/R).
Once you receive the payment from whole foods you would reduce your A/R account by that amount (credit A/R) and receive in the cash (debit cash).
An example that you may see in your day-to-day life would be something like…When you go to the doctor’s office, they typically bill you later and it has a due date sometime in the future, this is an account receivable for the doctor
Why give customers credit?
It is very common in the business world to extend credit to customers, especially if it is already a standard in the industry you operate in. Sometimes you are forced to give customers credit in order to sell to them. In this example, you are a lowly small ice cream start-up company. If you want to do business with Whole Foods, you probably have to just accept that they will only do business with you if you accept their terms.
The problem of an accounts receivable balance (the problem of extending credit)
The simplest answer is… They might not pay you! The customer could just not pay you (if it is a direct-to-consumer business) and the same could happen if you are selling to a company. They may disappear never to be heard from again! A company (or individual) could even go bankrupt.
It requires more management … If you sell on credit you will have to watch your accounts receivable, monitor aging, and chase people down for payment. If you only accepted payment at time or order or on delivery you wouldn’t have to worry about tracking A/R.
Working Capital Drag … The higher you’re A/R balance goes, the more cash you are owed that you DON’T have. This is cash that could be used to buy more raw materials to make more product to sell. It is cash you could use to pay yourself or your employees, or 100 different uses. If you get too much cash tied up in A/R you might even have to go take out a loan or get some temporary funding!
A few other details
Accounts Receivable is typically cash that is owed in around 30-60 days. For payment terms that a company extends beyond 1 year, this is no longer a “current asset” and would have to move into some sort of long-term receivable account.
For every Account Receivable, there is probably an Account Payable out there! In the example above our theoretical company has an Accounts Receivable balance from Whole Foods. However, Whole Foods most likely has an Accounts Payable balance on their books as they have a liability to you and your ice cream store!
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