What is Accounts Receivable?

Accounts receivable refers to money due to a seller from buyers who have not yet paid for their purchases. The amounts owed are stated on invoices that are issued to buyers by the seller. The issuance of an invoice implies that the seller has granted credit to a customer. The total amount of accounts receivable allowed to an individual customer is typically limited by a credit limit, which is set by the seller's credit department, based on the finances of the buyer and its past payment history with the seller. Credit limits may be reduced during difficult financial conditions when the seller cannot afford to incur excessive bad debt losses.

Trade Receivables vs. Non-Trade Receivables

Accounts receivable may be further subdivided into trade receivables and non trade receivables, where trade receivables are from a company's normal business partners, and non trade receivables are all other receivables, such as amounts due from employees. The amount of non trade receivables is usually quite small. The bulk of the attention of the collections staff will be on monitoring trade receivables, while someone outside of the receivables group will probably be in charge of collecting non-trade receivables.

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Example of Accounts Receivable

As an example of accounts receivable, a farm supply business sells a tractor to a farmer for $75,000. The sale is on credit. As soon as the tractor is delivered to the farmer, the business records an account receivable on its books, which is an asset. The business has given the farmer 60-day terms for paying the receivable. After 60 days, the farmer makes full payment, which is essentially a replacement of the receivable on the books of the business with cash.

Accounting for Accounts Receivable

When an invoice is issued to a customer, the seller debits the accounts receivable account (an asset account) and credits the sales account (a revenue account). When the seller receives a cash payment from the customer, the entry is a debit to the cash account and a credit to the accounts receivable account, thereby flushing out the receivable.

If a customer cannot pay an invoice, then the seller accounts for it by debiting the bad debt account (an expense account) and crediting the accounts receivable account, thereby flushing out the receivable.

Advantages of Accounts Receivable

Credit is usually granted in order to gain sales or to respond to the granting of credit by competitors. Allowing more credit to customers can expand the number of potential customers for a business, resulting in an increased market share. This is an especially useful tactic when a competitor decides to reduce the amount of credit offered, so that a firm offering more credit is in a good position to attract them.

Disadvantages of Accounts Receivable

Expanding the amount of credit offered to customers can mean that a firm’s bad debts increase. This is especially likely when a firm maintains a loose credit policy during an economic downturn, when customers may struggle to pay their bills. In addition, having more receivables increases the working capital requirements of a business, which may call for additional funding to keep it solvent. Furthermore, additional billing and collections staff are needed to create invoices and monitor payments, respectively.

Accounts Receivable Optimization

A business is optimizing its use of accounts receivable when selling one additional dollar of goods or services on credit will not longer generate any additional profit. This means that it still makes sense to extend credit to customers even when a portion of these sales must be written off as bad debts, as long as these sales still generate profits that exceed the bad debt losses. This has different implications, depending on the profit margins being generated. When products generate substantial profits, then it makes sense to offer credit to most customers, because the profits are so large that they exceed the amount of bad debts. Conversely, when the profit per unit is quite low, a business cannot afford to have many bad debts, so it is extremely careful in extending credit to customers, resulting in very low accounts receivable.

Presentation of Accounts Receivable

Accounts receivable is listed as a current asset on the seller's balance sheet. Accounts receivable are commonly paired with the allowance for doubtful accounts (a contra account), in which is stored a reserve for bad debts. The combined balances in the accounts receivable and allowance accounts represent the net carrying value of accounts receivable. A sample presentation of accounts receivable within a balance sheet appears in the following exhibit.

Accounts Receivable Financing

There are several ways to use accounts receivable to obtain financing for a business. One is to use the receivables as collateral for a loan. Receivables are prized by lenders, because they are usually easily convertible into cash within a short period of time. Or, the receivables may be sent to a factor in exchange for immediate cash; the factor is paid when the receivables are collected, so the net effect is to accelerate the collection of the receivables. The main problem with factoring is the high interest and fee cost associated with these arrangements. A third option that is available to large firms is to securitize the receivables, where the company issues securities to investors that are backed by outstanding receivables.

Accounts Receivable vs. Accounts Payable

Accounts receivable is comprised of those amounts owed to a company by its customers, while accounts payable is the amounts owed by a company to its suppliers. Accounts receivable appear on the company’s balance sheet as an asset, while accounts payable appear as a liability. A services business tends to have a higher proportion of receivables than payables, since most of its expenses relate to compensation. A retail business tends to have a higher proportion of payables, since it is purchasing its main input from suppliers (merchandise).

Accounts Receivable vs. Notes Receivable

A seller may find that its customers cannot pay their receivable balances when due, in which case an option is to convert these receivables into notes receivable. In a notes receivable arrangement, the customer agrees to a specific repayment schedule, typically with an interest charge added on. If the terms of the agreement allow for it, a note receivable may allow the seller to attach the assets of the customer and gain payment by selling the assets.

Accounts Receivable vs. Trade Receivables

The accounts receivable classification includes any receivables owed to an organization. This is not the case for trade receivables, which are a subset of accounts receivable. Trade receivables are only those receivables generated through the ordinary course of business, such as amounts that customers owe in exchange for goods shipped to them. The accounts receivable classification is also comprised of non-trade receivables, which is a catchall for any other type of receivable. For example, amounts owed to the company by its employees for personal purchased made on their behalf would be classified as non-trade receivables.