Accounts Receivable (AR): Definition & In-Depth Explanation

Accounts receivable (AR) refers to the money owed to a company by its customers for goods or services that have been delivered but not yet paid for. This financial measure represents a line of credit extended by the company, typically due within a short period ranging from a few days to a fiscal or calendar year. Accounts receivable is listed as a current asset on the balance sheet because it is money that is expected to be received within one year. Effective management of accounts receivable is crucial for maintaining healthy cash flow.

Purpose:

The purpose of accounts receivable is to facilitate the sale of goods or services without immediate payment. By extending credit to customers, companies can increase their sales and customer base. The management of accounts receivable involves assessing customer creditworthiness, setting credit terms, and ensuring timely collection. Efficient management helps a business improve its liquidity, reduce bad debts, and strengthen customer relations.

Example:

A graphic design firm completes a project for a client who agrees to pay within 30 days. Once the invoice is issued, the amount due from the client is recorded under accounts receivable on the firm’s balance sheet. When the client pays the invoice, the cash received is recorded, and the amount is removed from accounts receivable.

Related Terms:

• Bad Debt: Money owed to a company that is unlikely to be paid and written off as a loss.

• Cash Flow: The total amount of money being transferred into and out of a business, especially affecting liquidity.

• Revenue Recognition: The accounting principle that outlines the specific conditions under which revenue is recognized and determines how to account for it.

• Credit Policy: Guidelines a company follows to determine the creditworthiness of potential customers, which dictate terms of credit and how credit is managed.

FAQs:

1. What is the difference between accounts receivable and accounts payable?

   Accounts receivable are financial assets representing money owed to the company by its customers. In contrast, accounts payable are liabilities representing money a company owes to its suppliers.

2. How can businesses improve their accounts receivable turnover?

   Businesses can improve accounts receivable turnover by implementing stricter credit policies, offering early payment discounts, conducting regular reviews of customer credit limits, and using automated reminder systems for due payments.

3. What happens if accounts receivable are not collected?

   Uncollected receivables can become bad debts, negatively impacting a company's financial health by reducing cash flow and potentially leading to liquidity problems.

4. Is it common for businesses to sell their accounts receivable?

   Yes, some businesses use factoring or sell their receivables to a third party (often at a discount) to receive immediate cash, reduce risk, and outsource collections.

5. Why do companies allow accounts receivable to accumulate?

   Allowing receivables to accumulate can help companies boost sales by offering customers the flexibility to pay later, making purchasing easier and potentially increasing customer loyalty.