Understanding Accounts Receivable

Part of running any good business is having an understanding of your finances on an intimate level. One part of the revenue cycle that all businesses need to have a firm grasp on is accounts receivable. Without understanding accounts receivable, bringing in money using the revenue cycle will be difficult. 

In this article, we’re going over everything you need to know about accounts receivable so that you can bring in money as efficiently and effectively as possible.

What Are Accounts Receivable?

Accounts receivable, or AR, are entries on the balance sheet for your business that represent money owed to your business for goods or services. These accounts have yet to be paid on by customers and are a balance due from the client. Accounts receivable are any accounts on the balance sheet that were purchased on credit, hence their outstanding nature.

These accounts are considered assets on the balance sheet and are indicative of short-term balances due, specifically. Short-term can mean any number of things but normally refers to a date range of a few days all the way up to a fiscal year.

Accounts receivable are recorded as an asset on the balance sheet because of the legal obligation the client has to pay the business in exchange for goods and services. Accounts receivable are considered current assets as the payments from clients are typically due within a year’s time. 

When accounts have receivables, it’s because a client has purchased goods or services with credit. The business determines then the debt will be collected.

Accounts Receivable vs. Accounts Payable

Accounts receivable and accounts payable are essentially opposites of one another, as the two sides of a single coin. Accounts receivable are asset accounts, while accounts payable are liability accounts. An asset account is an account that you expect to receive money on. Hence the name accounts receivable. 

A liability account is an account that you expect to pay or spend on. Hence the name accounts payable. When you have an account that’s determined to fall under accounts receivable for your business, the account that the client creates would be an example of accounts payable. You cannot have one without the other.

The Benefits of Accounts Receivable

Accounts receivable often reflect growth and success in a business, as they often indicate jumps in sales. When a business can increase sales, overall the business becomes more profitable and more successful. 

By opening lines of credit to customers and clients, you’re able to increase your sales and maintain revenue, so long as the customers and clients pay on time. These credit lines can also help create better relationships with your customer base, as it places your trust in them, which can be incredibly valuable when it comes to social credit.

How to Set Up Accounts Receivable for Your Business

Because of the positive light that accounts receivable and lines of credit can create for your business, you may be considering setting up an accounts receivable system. If so, check out the following steps on how to get started with accounts receivable.

1. Develop an Approval Process

If you are considering opening lines of credit for your clients or your customers, you’ll want to be sure that their credit indicates a positive relationship with them. Typically, if you want to create lines of credit for customers, you’ll want to develop a specific process to be followed each time a customer wants to create a line of credit, and thus, an account receivable. Consider the following:

  • Use a credit application that gathers information relevant to the credit approval process, such as demographics, income specifications, and credit history. Pre-made credit applications are available online or can be found in office supply stores.
  • Make sure that you create specific outlines and terms regarding your accounts receivable and when payments for goods and services are due. Generally, when just starting with accounts receivable and lines of credit, you’ll want sooner due dates until the process is established.

2. Invoicing

After a line of credit has been established and you’ve begun using accounts receivable, make sure that invoicing customers and clients is specific and well-documented. Generally, invoices are provided immediately for goods and services and can be broken down by line items for the products received and any taxes or additional fees.

  • For clearer invoicing, be sure to include the terms of the credit and your account receivable on the invoice itself. This clears up any confusion that could occur regarding the time frame.
  • Most accounting software allows for accounts receivable to be added to the books, making the documentation and invoicing much easier on you, the business owner.

3. Monitor Accounts Receivable

A crucial part of having accounts receivable is monitoring to ensure that they’re being paid correctly. A number of software will allow you to follow your accounts receivable through the revenue cycle and alert you when the payments for accounts are coming due. 

The following items must always be kept in consideration:

  • Provide statements and reminders when due dates for open accounts are coming closer; no one likes to be “surprised” even when they should be aware of the terms.
  • Keep an eye on payments coming due, and always know when the next payments are due from clients. If you don’t enforce a strict payment policy and schedule, your clients won’t adhere to one.

4. Get Paid

The most crucial part of having accounts receivable and open lines of credit within your business is getting paid on those accounts. If you aren’t paid for them, you cannot continue to generate revenue and might be handing our services for free. It’s every business’s worst nightmare to rack up bad debt.

  • When payments come in, be sure to post them to the correct account so that you can keep accurate books regarding your outstanding accounts receivable.
  • Offer payments in a number of ways because this makes doing business with you much easier. Allow clients to provide payment via mail or electronic means, keeping in mind any fees that electronic payment systems may include.
  • Trust, but verify that payments are posted correctly. Discrepancies lead to errors further down the road and headaches for both you and the client or customer.

Keep an Aging Schedule

When tracking your accounts receivable, it’s very useful to keep an aging schedule of the AR. Aging schedules allow you to keep track of the accounts that need the most attention. These accounts are usually ones with older outstanding balances. Aging schedules are built around the terms defined in your accounts receivable and lines of credit and can be used to monitor clients who pay on time, those who need gentle reminders, and those that may not be paying at all.

Generally, the higher the outstanding age on an account, the less likely the client is to pay, and the account will most likely end up going into bad debt. An aging schedule is a good tool to use to monitor all of your accounts receivable and can tell you at a glance who needs to be reminded to pay and who is all caught up with their payments.

But what if a customer or client doesn’t make their payments on time? What if they don’t pay at all?

From Account Receivable to Bad Debt

Not all clients and customers pay. That’s just part of running a business, unfortunately. When you have an account receivable open with a client and don’t pay after a certain amount of time, you can generally assume that they’re not going to pay. When this happens, the account receivable ends up becoming what’s known as a bad debt.

Oftentimes, businesses will set up an allowance for bad debts, which will help determine the realistic expectation for account receivable for a certain period of time. If accounts are not written off to bad debt, then the expected revenue from accounts receivable will be too high and often unattainable.

The Dreaded Collection Agency

When an account slips from active AR and into a bad debt status, typically, you’re done monitoring it. However, if the balance is high, or if you fully expect to be paid for the goods and services you’ve provided, hiring a collection agency is always an option. The agency will most likely take a cut on the revenue collected, but some money is better than no money in these cases.

The Takeaway

Accounts receivable are a fantastic way to create trust with your clients and customers, as well as a way to indicate that your business is growing. While not all services can be provided via lines of credit, most can, and often this will allow you to create better relationships with the community that you serve. Accounts receivable are an asset to you, as well as to your business.

 

Sources:

A Beginner’s Guide to Accounts Receivable | The Blueprint

Understanding Accounts Receivable (Definition and Examples)

Accounts Receivable (AR) Definition 

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