What is Accounts Receivable? Definition
Accounts Receivable
What is Accounts Receivable? Simple Explanation
Accounts receivable represents money owed to your company by your customers. It refers to the money your customers owe you for goods or services that have been delivered or provided but not paid for.
It represents a current asset on the balance sheet and reflects outstanding invoices or credit sales expected to be collected within a short period, typically 30 to 90 days.
Is Accounts Receivable Important?
Yes, accounts receivable (AR) is very important for businesses. Here’s why AR is critical:
Cash Flow Management
AR is a key component of a company’s cash flow. Efficient AR management ensures the business has enough cash to cover operational costs, pay employees, and invest in growth.
Financial Health Indicator
High AR might indicate strong sales, but it can signal potential liquidity issues if customers are slow to pay. Monitoring AR gives insights into the company’s financial stability.
Customer Relations
Proper accounts receivable (AR) practices, such as timely invoicing and effective follow-ups, help maintain good customer relationships while ensuring payments are collected.
Business Planning and Forecasting
AR data helps with forecasting future cash flow, allowing businesses to budget and make informed decisions about investments and expenses.
Risk Management
Managing AR helps businesses identify customers who may have difficulty paying their invoices. This enables proactive steps, such as adjusting credit policies or initiating collections efforts.
Effective AR management ensures adherence to a company’s internal financial controls and audit requirements, reducing the risk of fraud or misstatement.
Compliance and Reporting
-For accounting purposes, AR affects the balance sheet and needs to be accurately recorded for financial reporting and compliance with accounting standards, regulatory requirements, and tax laws. Here’s how it breaks down:
Accounting Standards
Businesses must comply with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), depending on their jurisdiction. These standards dictate how AR is recorded, reported, and valued, including rules for bad debt provisions and revenue recognition.
Regulatory Requirements
Some industries or regions have specific rules regarding credit terms, invoicing practices, and the treatment of overdue accounts. Failing to comply can lead to penalties or legal action.
Tax Laws
AR impacts taxable income. For example:
- Revenue must be recognized correctly to calculate taxes owed.
- Writing off uncollectible accounts as bad debts may require compliance with specific tax regulations to claim deductions.
What is Accounts Payable?
Accounts payable is the money a company or professional owes for the products and services they have purchased on credit. So, accounts payable represents all the money a company owes.
Accounts Receivable vs. Accounts Payable
The simplest way to remember in the beginning is accounts receivable is money coming in, while accounts payable is money going out.
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Accounts Receivable Management
Accounts Receivable Management is the work a business needs to do to get paid.
While the definitions in their shortest form are simple – if you’re looking for information about working in an accounts receivable department, it gets a little more complicated.
Working in Accounts Receivable
The work of the accounts receivable department is generally called Accounts Receivable Management, and we can break it down into five main categories, they are:
- Credit Management
- Billing or Invoicing
- Posting Payments
- Reconciliations
- Collections
I’ve seen advertisements for companies looking for accounts receivable staff with much longer lists, but these are the five main areas.
What is Credit Management?
Credit management is the process your company has for deciding whether or not a customer can purchase on credit and if so how much? Sort of like a credit card but with a business instead of a bank.
There are several steps in the process of approving or disapproving credit, they include:
- Information gathering (you need a good credit application for this)
- Application processing
- Evaluation and decision making
Once a company has extended credit to a customer that credit needs to be managed. A credit manager even in a small company will want to watch for several things, such as:
- Up to date contact information
- Credit limit violations
- Late invoices
- Need for limit increases or decreases
Billing/Invoicing
Once credit has been established and product shipped, or service rendered, it’s time to do the billing or create the invoice. Those aren’t two things; billing and invoicing are two words describing the same process, so don’t let that confuse you.
Whatever you call it at your company, it’s the next step, and another place collection problems are commonly created. Invoicing errors are the surest way to be certain you don’t get paid on time.
Posting Payments
If you’ve handled your credit management thoroughly and you’ve done your invoicing correctly, and on time, the next step in the accounts receivable management process will be posting payments.
This subject could use a post of its own but suffice to say this is yet another area where we have the opportunity to create collection problems.
Here are the top five posting errors I’ve encountered over the years.
- Posting to the oldest invoice first.
- Not posting and posting late.
- Posting the wrong date.
- Posting overpayments incorrectly.
- Posting underpayments incorrectly.
You may have noticed I’ve mentioned creating collection problems several times in this article. That’s because I’ve spent a good portion of the last 30 years collecting accounts receivable and I’ve learned that most collection problems are preventable. You can save yourself and your company a lot of grief and money by implementing best practices in your Accounts Receivable department. It’s easy to blame the customer, but more often than not, the issues begin within our own company, not with the customer.
Reconciliations
Mistakes will happen, and when they do, you’ll need to be able to reconcile your accounts. That means you need to know how to prove that a given account balance is accurate. You need to be able to “do the math” as they say.
It’s easy if you haven’t made a lot of the kinds of mistakes we talked about earlier. The more posting or invoicing errors, the harder it gets to reconcile. Just think of a two-step math problem or a five-step math problem, which is easier?
In accounts receivable, you’ll want the amount you believe your customer owes to match what your customer believes he owes.
That means your customer agrees he owes the amount on the invoice. If he does not agree, you’ll need to reconcile the difference, i.e., figure out what the problem is. If you can not reconcile the account, you may end up with a collection problem.
And that is the last but mostly avoidable step in the Accounts Receivable Management Process.
Collections
Statistically, only about 30% of any given database of customers pay on time. Another 30% or so pay within reasonable terms, and the rest require some level of attention.
That means out of every ten customers, you’ll probably have to do something to collect from 4 of them.
And like everything else we’ve discussed in this article, there are several steps to an effective collections process. These include but are not limited to;
- Deciding how to measure collection results
- Identifying late invoices
- Contacting customers with invoices that are beyond terms
- Tracking your collection work
Deciding How to Measure Results
There are many ways to measure collections effectiveness. You might measure any or all of these (though we think all is a bit of overkill)
- DSO – Days Sales Outstanding
- CEI – Collectible Effectiveness Index
- Acceptable percentage of bad debt write-offs
- Acceptable percentage of receivables by aging
Hopefully, you’ll find all of this in your company’s credit policy.
Identifying Late Invoices
You’ll need two things to decide which invoices are far enough beyond terms to justify contacting the customer.
- Familiarity with your company’s credit policy
- Your aging
Your credit policy will tell you when and your aging will tell you who. Your objective should be to contact every customer that has a balance that falls outside of the parameters established in your credit collection policy.
Contacting Customers
Deciding how to make contact is your next task. You can use any or all of these tactics;
- Letter campaign – delivered via email and snail mail
- Fax a statement, invoice or request for payment status (yes fax is still a thing, though it often goes straight to email these days)
- Text message
- Call Campaign
Collection call campaigns have been our bread and butter for the last 30 years, and if you hate making collection calls (and most people do) but need them, we welcome your inquiry.
For additional perspective read Eight Steps to An Effective Dunning Campaign originally published at Tesorio
https://www.tesorio.com/blog/eight-steps-to-an-effective-dunning-campaign
last updated 12/24/2019 12:33:50 PM
Questions? Call me at 800-201-CA$H (2274) my extension is 110.
