What Type of Asset Is Accounts Receivable?
Understand accounts receivable as a key business asset. Learn its financial classification and how its true value is determined for accurate reporting.
An asset is an economic resource controlled by an entity, expected to provide future economic benefit by generating income, converting to cash, or contributing to financial health. Accounts receivable is a common asset for many companies, playing a significant role in their financial position.
Understanding Accounts Receivable as an Asset
Accounts receivable (AR) refers to money owed to a business by its customers for goods or services delivered but not yet paid for. This financial claim arises when a company extends credit, allowing a customer to receive a product or service immediately and pay at a later date. For example, when a plumber completes a job and sends an invoice, the amount due becomes an accounts receivable for the plumbing business.
These claims are assets because they represent a legally enforceable right to receive future cash, providing an economic benefit. Businesses offer credit sales, often with payment terms ranging from a few days to 90 days. This practice means the company has accepted a promise of payment, transforming the future cash inflow into a present asset.
Classifying Accounts Receivable
Accounts receivable is presented on a company’s balance sheet, a financial statement providing a snapshot of assets, liabilities, and equity at a specific point in time. It is classified as a “current asset.” A current asset is an economic resource expected to be converted into cash, consumed, or sold within one year or the company’s normal operating cycle, whichever is longer.
The short-term nature of accounts receivable aligns with this classification, as most invoices are collected within a few weeks or months. This places accounts receivable among other liquid assets like cash, cash equivalents, and inventory, which help a business meet its short-term financial obligations. Its consistent classification as a current asset highlights its importance in assessing a company’s liquidity and ability to manage day-to-day operations.
Assessing the Value of Accounts Receivable
While accounts receivable represents money owed, not every dollar will necessarily be collected. To provide a realistic picture of a company’s financial health, accounts receivable is reported on the balance sheet at its “net realizable value.” This net realizable value is the estimated amount of cash a company expects to collect from its outstanding invoices.
To arrive at this value, businesses use a “contra-asset account” called the “Allowance for Doubtful Accounts.” A contra-asset account reduces the gross amount of an asset to reflect its estimated true value. For accounts receivable, it accounts for amounts likely to be uncollectible due to customer defaults or other issues.
This allowance is necessary because customers might default on payments, go bankrupt, or dispute charges, making a portion of the receivables uncollectible. By establishing this allowance, companies uphold accounting principles by matching potential bad debt expenses to the period in which the related sales occurred, rather than waiting for actual defaults.