Numbers undoubtedly rule the finance world. For example, making sales and actually getting owed money are two different things – however, in many companies, the former gets more emphasis than the latter.
This is where accounts receivables come into the picture, and a finer concept, known as AR accounting, fits in. Its successful implementation and oversight seamlessly differentiate between sales numbers and return on investment (ROI).
In this article, we'll journey through AR accounting concepts, exploring the symmetries and complexities that underpin it. Whether you're a financial expert or a beginner accountant, this article will have you covered.
What is AR accounting?
Accounts receivable (AR) accounting is the process involved in how companies take care of pending receivables from customers.
Managing your cash flow, working capital, and achieving financial stability relies heavily on cornerstone AR accounting. Implementing and following it ensures that you receive payments on time, mitigate bad debt risk, and achieve a healthy cash position.
AR Significance in Business and Finance
Accounts receivable is a critical aspect of business and finance. It has high significance in your company’s day-to-day operations and upkeep of financial health.
Let’s look at how AR is vital in business and finance:
- More sales. Extending credit and setting flexible payment terms to customers through AR can increase sales and attract more customers.
- Working capital management. AR is a critical component of your working capital, which represents its short-term financial health. Ensuring you have your accounts receivables well-handled ensures the necessary cash flow to cover daily operational expenses.
- Improved cash flow. Effective AR management contributes to a steady cash flow, allowing you to meet your financial responsibilities. Timely AR collections can help you maintain liquidity.
- Effective credit management. While extending credit can boost sales, it also poses a non-payment risk. Managing AR includes evaluating customer creditworthiness and establishing limits to mitigate bad debt risk.
- Inventory management. If you can predict when payments will be received, you can better plan for inventory needs and reduce carrying costs.
- Tax implications. AR can affect your tax liability. Recognizing revenue when the sale is made can have implications for when taxes are due, particularly if you’re following accrual accounting methods.
A Breakdown of AR Debits and Credits
AR debits and credits involve AR transactions, which represent the amount of money your customers owe.
Debits and credits are fundamental concepts in double-entry accounting, where each financial transaction has equal debits and credits, ensuring a balanced accounting equation:
Assets = Liabilities + Equity
Here's how AR credits and debits work:
AR debits increase the amount of money your customers owe you.
This happens when you make a sale on credit (meaning, the customer agrees to pay at a later date). This transaction increases your AR amount.
You can record an AR debit in your journal with an entry shown in the example below:
Credit: Revenue or Sales
AR credits reduce the amount of money you’re owed. This happens when a customer pays their invoice and this decreases your AR balance.
Recording an AR credit in your general journal is generally done like this:
Debit: Cash or Bank (or another applicable account)
Is AR a debit or credit?
AR can play both sides – it can be a debit and a credit. Here's the deal - there’s a concept in accounting known as “double-entry.”
It's like a seesaw: you need to have equal weights on both sides to keep it balanced. That's where debits and credits come in. When you're making a sale on credit (meaning your customer will pay later), you give your AR a boost by debiting it. But, when your customer actually pays up, you credit the AR. Now you have money in the bank. This two-way system keeps everything tidy, makes sure the books are balanced and helps you keep track of who owes you.
Accounts Receivable Credit Terms
AR credit terms directly affect when your company can expect to receive payments.
When your customer buys from you on credit, they make a “promise-to-pay” (PTP) at a later date.
Most companies follow NET30 or NET60 (some even follow NET90) which means the customer promises to pay no later than 30 or 60 days after the invoice is issued.
To ensure prompt payment, you can provide incentives for customers who pay sooner.
Being strategic about credit terms and incentives is one way you can leverage the AR function to improve business operations and head towards success.
Accounts Payable vs. Accounts Receivable: An Overview
In a nutshell, the primary distinction between accounts payable (AP) and AR lies in which direction the transaction is heading.
AP signifies money owed by your company to your suppliers and creditors, while AR represents money owed to you by customers and clients.
Both AP and AR are crucial for managing a company's cash flow and financial stability.
Accounts payable is a fundamental component of your financial operations. It represents the money you owe to creditors or suppliers for goods or services that have been received but not yet paid for. The company acknowledges its debt and is expected to pay these amounts in the future.
AP represents a current liability on your balance sheet. It signifies short-term obligations that must be settled in the next few weeks or months.
In terms of money flow, AP involves funds moving out of the company when it pays its bills to suppliers. It's a financial responsibility to honor.
Say you purchase $5,000 worth of merchandise from a supplier on credit.
Here's how AP works in this scenario:
- Transaction: You receive the goods from your supplier, and they invoice you for $5,000, with a NET30 payment term.
- AP Entry: You record the invoice as an accounts payable entry, acknowledging that you owe the supplier $5,000. This is a liability on the balance sheet.
- Payment: Within the next 30 days, you pay the supplier the $5,000. The AP entry is then updated to reflect that the liability has been settled.
Accounts receivable is equally significant but represents a different financial aspect of your operations. It is the anticipation of future cash inflow, representing the money that you are entitled to receive from your customers. It denotes the money that is owed to you by customers or clients for goods or services that have been provided but not yet paid for.
AR represents an asset on the company's balance sheet. It reflects the company's expectation of receiving payments in the future, usually in the short term.
AR involves funds moving into the company when customers make payments. It's a financial asset representing expected income.
Now, let's consider an example of accounts receivable in your retail business:
- Transaction: A customer purchases $1,000 worth of products, and you allow them to pay in 30 days. You provide the products to the customer and create an invoice.
- AR Entry: You create an accounts receivable entry for $1,000, which represents revenue from sales and the amount you are entitled to receive from the customer. This is an asset on your balance sheet.
- Payment: The customer pays the $1,000 within the 30-day credit term. You update the AR entry to reflect that you've received the payment.
Common AR Terminology Explained
- Aging report: You use an aging report to categorize accounts receivable based on how long they've been outstanding. It helps collectors spot overdue accounts, prioritize who to reach out to, and assess the effectiveness of their AR collection efforts.
- Credit limit: A credit limit is the maximum credit extended to a customer. It places a cap on the total amount a customer owes you and further purchases are restricted until they clear existing balances.
- Dunning: Sending reminders to customers with overdue accounts is called dunning. The term also refers to the actual communication or notification sent to these customers.
- Doubtful Account Allowance: An allowance for doubtful accounts is a contra-asset account (an asset account in which the natural balance of the account will either be a zero or negative balance) on the balance sheet. It represents the estimated portion of accounts receivable that will not be collectible. The amount is based on historical data and industry-specific standards.
- Bad Debt: Bad debt is money owed by customers that you don’t expect to collect and it must be written off as a loss.
- Write-Off: A write-off is the process of removing an accounts receivable balance from the financial records because it is considered uncollectible.
- Payment Terms: Payment terms specify when a customer is expected to pay their invoice. NET30, NET60, and NET90 are some examples of payment terms, meaning a customer has a 30, 60, or 90-day limit to clear their payment from its date of issue.
- Sales on Account: This refers to sales made to customers on credit, where customers receive the products or services even before paying.
- Sales Returns and Allowances: This tracks the value of products or services that customers have returned or for which allowances have been made due to issues like disputes, defects, or transaction errors.
- Reconciliation: An AR Reconciliation involves ensuring that the accounts receivable records match the general ledger, and helps maintain financial reporting accuracy.
- Collections: Collections involve pursuing and receiving payments from customers with overdue accounts. This involves sending reminders, contacting customers, and in some cases, taking legal action.
- Factoring: Factoring is a financial arrangement where a company sells its accounts receivable to a third party (a factor) at a discount. This provides immediate cash but at a cost.
Practical AR Bookkeeping Tips
Taking your AR to the next level needn't be hard. From personalized communication to aligning sales and finance can go a long way in making a large impact.
Let's look at some key AR bookkeeping tips:
- Personalized, proactive customer communication: Establish a practice of early and personalized communication with customers about upcoming payments. If they have historically delayed payments, be sure to follow up a few days before the due date to ensure they are aware of their payment obligations.
- Follow-up strategies: Tailor your follow-up actions based on how soon (or late) your customer pays you. Let your collectors prioritize the right accounts to reach out to, instead of doing it haphazardly.
- AR automation: Implement a receivables automation payment processing system that lets you reduce the manual tasks your collectors perform. AR automation reduces the risk of late payments and streamlines the AR process.
- Customer portal: Create a customer portal where clients can access their account details, view invoices, and make payments online, providing convenience and transparency.
- Automated cash application: Auto-match payments extract remittances from even unstructured data, and achieve straight-through posting with an automated cash application. Minimize manual intervention for your collectors.
- Get continuous customer feedback: Gather feedback from customers about your invoicing and payment processes. Use this input to make improvements and enhance customer satisfaction.
- Sales and finance alignment: Ensure that your sales team is aligned with AR processes. Encourage them to communicate any changes in customer relationships or orders that may impact AR. If there are gaps in the collaboration channels, implement fixes to avoid them.
- Regular revaluation of AR processes: Periodically reevaluate your AR processes and strategies. Continuously look for opportunities to streamline operations and improve collections efficiency.
AR accounting is not just about crunching numbers; it's about keeping your financial engine running smoothly.
By following best practices in AR accounting, you can make sure the money keeps flowing, bad debts are minimized, and your financial health remains robust.