What Is Accounts Receivable and Why Do Businesses Need It?

By Indeed Editorial Team

Updated 8 September 2022 | Published 29 September 2021

Updated 8 September 2022

Published 29 September 2021

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Accounts receivable is an important component of modern business transactions. It functions as a promise to pay money between a business and a customer, which is paid in the imminent future. The way a business records and deals with its accounts receivable is dependent on whether it's a small or large company. In this article, we answer the question, 'What is accounts receivable?', discuss why it's useful for businesses and discuss the processes involved in initiating accounts receivable.

What is accounts receivable?

When learning about accounting, you might be wondering, 'what is accounts receivable'? Receivables mean that a business transaction has happened, but the buyer has not yet paid. It refers to purchases made on credit for goods or services which usually require payments to be made in a short time period. These goods and services include product sales, donations or taxes and membership fees. For accountants, accounts receivable appears as an asset account on a company balance sheet and represents the money still owed. This account constitutes all company assets that are yet to materialise.

Companies may offer accounts receivable to loyal customers or other businesses who frequently buy stock or products from them. This is an extension of credit and allows the customer or business to pay what they owe in monthly instalments or within a limited time frame. A receivables accountant monitors the accounts receivable through accrual systems. This means that revenues or expenses get recorded as soon as a transaction occurs, rather than when payment is received. As a result, an accountant must oversee invoices and review when payments are due to ensure that the customer honours the transaction.

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Why are accounts receivable useful to businesses?

Accounts receivable are important for companies, as it allows them to measure their liquidity. It doesn't matter whether a company is small or large, accounts receivable are useful for measuring and attaining many aspects of a business. Reasons why it's useful include:

  • Accounts receivable allows valuers to determine the short-term assets a company can use to acquire stock or infrastructure with little risk.

  • The asset account allows accountants to calculate the receivables turnover ratio. This refers to how often a business has managed to collect on its accounts receivable balance successfully (such as payment within the specified time frame).

  • A receivables turnover ratio can measure the strength of a company and its operative measures. The more a business manages to collect, the stronger its reputation.

  • Since accounts receivable is a current asset, it measures a company's ability to manage short-term obligations without accumulating debt or using additional cash flows.

  • Accounts receivable can facilitate stronger bonds between a company and its customers.

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How to manage accounts receivable

The accounts receivable process aims to make receivables trackable and manageable. A good process allows receivables accountants to determine which accounts are due, which ones they've managed to collect successfully and which ones are overdue. Here are five processes accountants use to monitor accounts receivable:

1. Develop credit practices

Credit management teams or internal analysts determine whether a business is likely to offer a line of credit to a customer. They decide this by analysing a client's buying habits and seeing whether they're a repeat customer. If they decide to extend a customer's credit, they prepare a document outlining the terms and conditions of the sale. This document varies according to the scale of a transaction and the size of the business, but typically includes full disclosure on credit practices so that the creditor doesn't have any upper hand when it comes to collections.

The document needs to conform to consumer standards. A contract is usually set up and verified. Within this contract, companies outline how long the customer has to pay their debt. Smaller companies may offer smaller time frames, as they have a restricted income compared to large companies or business chains. Credit practices dictate that companies usually need to pay the balance within one year or less since the accounts receivable are a current asset for that business year.

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2. Create an invoice

An invoice is the first stage in ensuring that a business generates income from its accounts receivable. It informs customers of all items they've purchased within the transaction, the individual costs of each item and when payment for them is necessary. Nowadays, invoices can be paperless as customers have the option to receive them via email.

Each invoice has a unique serial number that companies use to check the document for reference if a customer has any questions about their account. The longer a customer waits to receive an invoice, the longer they are likely to take paying it back. For this reason, companies endeavour to send invoices as soon as a purchase agreement is in place with a customer.

Related: How to write an invoice (with definition, steps and tips)

3. Track receivables

Account receivables appear as an asset on a company's balance sheet, as the customer has a legal obligation to pay the debt. This legal obligation guarantees payment and assets acquired. Accountants need to track receivables to make sure this is the case. Accountants must first ensure that the accounts adequately reflect the information on the invoice. Then, they update the ledger pertaining to a customer each time they make a payment towards their debt. This update reflects the new outstanding balance.

Some larger companies may have process automation or contract companies that update this information automatically. Where account information doesn't match the invoice or where payments have been successful but not recorded, accountants must correct the records. They also monitor subsidiary records and revenue accounts which feed into an account receivable account.

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4. Monitor successful accounts receivable payments

Businesses must update the system when the customer has fully paid a debt. This includes searching the invoice number for that particular accounts receivable and debiting the bank account. The business successfully completes the transaction, and the account is cleared of all items.

It's important that all entries made into the accounting system eventually equate to zero, as this makes it easier to track any outstanding payments. There is an incentive for customers to pay their accounts receivable early as it could lead to special discounts. If this is the case, a company must set up a special discount account and debit the amount awarded.

5. Note outstanding invoices

Outstanding invoices usually indicate bad debts or missed payments. Regular monitoring ensures that accountants are also constantly aware of any unpaid debts. They record the sales in that transaction and notify the customer. Accounts keep track of unpaid debts through a day's sales outstanding report, which documents how long an invoice has aged past its payment due date.

Typically, invoices age after 30-90 days, which is the usual time frame given to vendors to pay bills. If a company refuses to pay their invoices, this prevents them from receiving credit in the future. These accounts are referred to as 'bad debts' and, if the customer attempts to buy something on credit again, this information prevents accountants from honouring it.

Examples of how businesses use accounts receivable

There is a certain level of risk involved with accounts receivables, yet businesses offer them because it allows them to close sales. For this reason, they only use account receivables to manage longstanding or loyal customers. If such a customer is unable to pay for an item up front, a business defers payment by allowing the customer to purchase it on credit rather than debit. Customers who opt for this payment option may pay interest on their accounts. However, the cost is often small for those who prefer to operate on monthly budget systems.

Consider the following examples to help you understand how accounts receivable works:

Example 1

You own a fresh produce market and you have a regular customer who buys your fish every two weeks. You may choose to put a provisional agreement in place with this customer, who can take fish every two weeks up to a certain amount. The agreement requires that the customer must pay you back at the end of the month for the amount they have purchased. Therefore, you have accounts receivable for the customer.

Example 2

An electric company usually bills its clients only after they have received electricity. This means that the company has several records of accounts receivable as it waits for clients to pay them back over an allotted time period.

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