How the Accounts Receivable Process Works

Accounts receivable (AR) represents money owed to a business by its customers for goods or services delivered on credit. It is a claim for future payment, reflecting a short-term loan provided to customers.

Understanding Accounts Receivable

Accounts receivable is a financial term for funds a business is due from clients, often from unpaid invoices. It arises when a business delivers products or services but agrees to receive payment at a later date, typically within 30, 60, or 90 days. This arrangement functions as a line of credit extended by the seller to the buyer. AR is considered a current asset on a company’s balance sheet because these amounts are expected to be collected within one year.

Businesses offer credit to facilitate sales, build customer relationships, and remain competitive. AR represents a legal obligation for the customer to pay, making it a valuable asset.

Creating Accounts Receivable

Accounts receivable comes into existence through the extension of credit and the issuance of an invoice. When a business agrees to provide goods or services on credit, it establishes an agreement for future payment. This process begins with a customer order, followed by credit approval.

Once goods or services are delivered, the business generates an invoice. This serves as a formal request for payment and a transaction record. An invoice includes seller and buyer information, a unique invoice number, and the issue date. It details the goods or services provided, including descriptions, quantities, and prices. It also specifies the total amount due, any applicable taxes or fees, and payment terms like “Net 30,” meaning payment is expected within 30 days. The due date and accepted payment methods are also stated.

Monitoring Accounts Receivable

After accounts receivable are created, businesses must diligently monitor these outstanding amounts to ensure timely collection. Maintaining accurate records is important for cash flow management and identifying potential payment issues early. Businesses often use an accounts receivable ledger, which details all individual customer accounts and their respective outstanding balances.

A common tool for monitoring is the aging schedule, which categorizes receivables based on how long they have been outstanding. This schedule typically groups invoices into time buckets, such as current (0-30 days), 31-60 days past due, 61-90 days past due, and over 90 days past due. An aging schedule helps businesses prioritize collection efforts by highlighting older, potentially harder-to-collect debts. Regular review of these reports helps assess customer payment behavior, identify trends, and evaluate the effectiveness of credit policies.

Collecting Accounts Receivable

The collection of accounts receivable involves a systematic approach to secure payments for outstanding invoices. Once an invoice becomes due, businesses often begin with sending payment reminders, which can be automated through accounting software. This initial step aims to prompt payment without escalating the situation.

If payment is not received after reminders, businesses typically follow up with direct communication, such as phone calls or emails, to discuss the overdue amount. Establishing clear communication and having defined collection policies are important for maintaining customer relationships while pursuing payment. When payments are received, they are processed and applied to the corresponding invoices, reducing the outstanding accounts receivable balance. For significantly overdue accounts, businesses may consider more formal steps, such as sending dunning letters or, as a last resort, referring the account to a collection agency.

Accounts Receivable on Financial Statements

Accounts receivable holds a significant place on a company’s financial statements, reflecting its financial health and operational efficiency. On the balance sheet, accounts receivable is presented as a current asset, signifying money expected to be converted into cash within a year. This classification highlights its role in a company’s liquidity, or its ability to meet short-term obligations.

While accounts receivable is a balance sheet item, its creation directly relates to revenue recognized on the income statement under the accrual basis of accounting. Revenue is recorded when goods or services are delivered, regardless of when cash is received. This means that sales made on credit immediately increase revenue and accounts receivable. To provide a realistic picture, businesses estimate uncollectible amounts through an allowance for doubtful accounts, which reduces the net value of accounts receivable on the balance sheet. Changes in accounts receivable also impact the cash flow statement; an increase in AR indicates that more sales are on credit, temporarily reducing cash flow, while a decrease signifies more cash collections.