Accounts receivable

Definition

Accounts receivable refers to the outstanding amounts that a business is yet to collect from its customers or clients for goods sold or services provided on credit. It represents the short-term financial obligations owed to the company.

What is accounts receivable

When a business extends credit to customers, it essentially allows them to defer payment for a later date, creating an accounts receivable.

Some key points about accounts receivable include:

1. Credit transactions: Accounts receivable arise from credit transactions where a company provides goods or services to customers with an agreement for deferred payment. 
2. Recorded as asset: In financial statements, accounts receivable are recorded as assets on the balance sheet. They represent a claim that the company has on the payment from its customers. 
3. Terms and conditions: The terms and conditions for payment, including the credit period and any interest or discounts, are usually specified in the sales agreement or invoice. 
4. Working capital impact: Accounts receivable impact a company’s working capital. While they are assets, a high level of receivables may indicate potential liquidity issues.
5. Monitoring and collections: Businesses closely monitor their accounts receivable to ensure timely collection. This involves tracking overdue payments, sending reminders or statements to customers, and implementing collection strategies if necessary.
6. Bad debt provision: Recognising that not all accounts receivable may be collected, companies often establish a provision for bad debts. This is an estimate of the portion of receivables that may not be collected due to customer defaults.
7. Financial analysis: Analysts and investors may assess a company’s accounts receivable turnover ratio to evaluate how quickly it is collecting outstanding payments. A high turnover ratio is generally favourable, indicating effective credit management.

Example of accounts receivable

1. Service Provided on Credit:
   • On March 1st, ABC Services provides consulting services to a client, XYZ Corporation, and invoices them for £8,000. The payment terms are net 30 days, meaning XYZ Corporation has 30 days to pay the invoice.

   The accounting entry for this transaction is:

   $\text{Accounts receivable}(Asset)=\; \pounds 8,000$

   $\text{Service revenue}(Revenue)=\; \pounds 8,000$

   This entry reflects an increase in the accounts receivable asset, representing the amount owed by the client, and an increase in service revenue.

2. Payment within Credit Terms:
   • On March 25th, within the credit period, XYZ Corporation makes a payment of £8,000 to ABC Services.

   The accounting entry for the payment is:

   $\text{Cash}(Asset)=\; \pounds 8,000$

   $\text{Accounts receivable}(Asset)=\; \pounds 0$

   This entry reduces the accounts receivable and increases the cash asset to reflect the payment received.

In this example, accounts receivable initially represents the amount owed to ABC Services by its client for services rendered. The asset is later reduced when the payment is received within the specified credit period.