Q&A: What Is Accounts Receivable and How Does It Work?
Updated January 26, 2023
Accounts receivable is, in essence, the way a company uses IOUs. Many have set up proprietary credit checking systems that work alongside established credit checking companies to develop a streamlined accounts receivable system. Combined with the recent move towards automation, even smaller companies can capitalize on more efficient accounts receivable processes. In this article, we will look at the process of accounts receivable and how businesses use it.
What is accounts receivable?
Accounts receivable (AR) is the process of obtaining payment for services or goods. The term may also refer to the department in charge of billing. Within the field of accounting, the term “receivables” means that a business has made a sale, but hasn’t yet received the proceeds from that sale. A lot of companies allow their customers to buy items within their inventory on credit. These credited items fall under the AR general heading.
An example of AR is the way utility companies operate. Generally, these companies only bill you after the period in which you used their supply. All unpaid invoices sent to clients are considered accounts receivable.
The extension of credit to its customers by a business sets up the existence of an account receivable. AR can constitute a lot of a company’s assets that haven’t yet materialized. It usually comes due within a year or less from the time that the client initiates the purchase. One way to think of an AR for a non-specialist is as a short-term IOU that the customer gives to the business. The IOU is valid for a period during which the customer must pay off the balance on the account. Failure to do so will result in default.
How a typical accounts receivable process works
An AR process enables a business to determine what accounts are coming due, which ones are overdue and which ones the company has managed to collect successfully. The role of this particular methodology is to make the receivables manageable and traceable.
The processes for large and small firms may differ, thanks to the scale of their cash flows. Big companies can manage to hire credit management teams while smaller companies have to make do with internal analysts and advisors. Aside from these differences, there are four significant steps in setting up an AR process:
Developing credit practices
Accounting for AR
Developing credit practices
By analyzing a particular client, the business will decide whether they are interested in offering them a line of credit. They will prepare a document that outlines the terms and conditions for sale on credit. The company should include within the document full disclosure for credit practices. A lawyer would have to ensure that the document and agreement conform to all applicable federal laws. Terms and conditions tend to vary with the scale of the business as well. Larger firms offer longer periods for customers to repay their debt. Due to restricted cash flow from smaller firms, they tend to want to close their accounts receivable in a limited window and thus offer shorter payment periods.
The business would then create an invoice for the customer. The invoice is a document that gives the customer a rundown on the items they have purchased, the individual costs of each item and the expected time for payment. Invoices usually have a unique number that the company can use for referencing or retrieval. While in the past, most invoices were physical, today’s consumers have the option of a physical invoice or to go paperless with an e-invoice. Businesses should seek to send invoices out as soon as the buyer enters into a purchase agreement with them. The longer a customer takes to get an invoice, the longer they take to pay it.
The role of tracking the receivables from these credit payments falls to the accounts receivables officer. The AR officer enters the values for the purchase, updates the ledgers and generates the invoice for the purchase. Additionally, with each payment, the AR officer updates the ledger to reflect the new amount the client is expected to pay. Smaller companies tend to use professional accountants to operate their AR processes. They may not have enough funds to hire an AR officer as a stand-alone position. Larger companies sometimes have entire credit management facilities with AR officers assigned to areas as opposed to individual clients. Additionally, larger companies can leverage sophisticated software and process automation.
Accounting for AR
The company’s collections officer defines the due date for payments. Once the business manages to identify unpaid debts, the accounting department goes ahead and records the sales. The reconciliation of accounts includes accounting for unpaid debts, bad debts and early-payment customers.
Read more: Learn About Being an Accountant
How businesses use accounts receivable
Accounts receivable is a flexible method for businesses to manage privileged clients. Occasionally, a business might consider selling a particular item to a client, but the client isn’t able to pay for that item as a single transaction.
The business may decide to offer the customer a chance to pay for the item over a certain period, with the expectation that the customer will have to pay slightly more because of interest on the account. Goods bought on payment plans or hire purchase are attractive to consumers who operate monthly budgeting systems. Businesses offer these methods of payments to clients because it allows them to close sales, even though some risk is involved.
Occasionally, a business might have a regular customer that purchases goods over a specified period. For example, a restaurant buys beef from a butcher every week up to a certain amount. In this case, once a business relationship gets established, the butcher may offer the restaurant owner a provisional agreement. The butcher supplies the restaurant, who then pays him every month for the beef that they got from him throughout that period. In this case, the restaurant would be in the butcher’s accounts receivable.
Accounts receivable is a crucial part of measuring a company’s liquidity. Valuators look at a company’s history of AR to determine how much short-term assets the company can safely dedicate to the acquisition of stock or infrastructure. An accountant doing a fundamental analysis of a business would look at how often the business managed to collect on its accounts receivable balance. The special relationship is referred to as the business’ accounts receivable turnover ratio. The more often the business managed to collect, the stronger the business’ reputation would be.
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