Understanding the nature of accounts receivable is pivotal for your company’s success.
At its core, an “accounts receivable” represents the amount of money owed to a business by its customers after goods or services have been delivered but not yet paid for. Essentially, it’s a promise from the customer to pay the business a specified amount by a certain date.
Assets or Liabilities
Accounts receivable are considered assets, not liabilities. The reason for this is simple: assets provide a future economic benefit to a business, while liabilities represent obligations. When a business has accounts receivable, it has a claim to future cash inflows. In other words, it expects to receive money, which is a benefit. On the contrary, if a business owes money, that’s considered an account payable and is classified as a liability.
To better grasp this concept, let’s delve into a couple of examples:
Jane operates a boutique that sells designer clothing. A customer walks in and falls in love with a dress but doesn’t have the money on hand to pay immediately. Jane, trusting her regular customer, agrees to let her take the dress and pay within 30 days. This promise to pay becomes an accounts receivable for Jane’s Boutique. The boutique has essentially sold the dress, and while they haven’t received the money yet, they expect to do so in the near future. This future cash inflow is an asset to Jane’s business.
Techy Repairs fixes electronics. A corporation hands over 50 laptops for repair with an agreement to pay within 45 days after the service is rendered. Once the repair service is completed, even before the payment is made, Techy Repairs records this amount as accounts receivable. Again, the expected payment is an asset, representing money that will flow into the business soon.
In both examples, the businesses expect to receive money for the services or goods they’ve provided. The keyword here is “expectation.” Since they anticipate receiving cash or its equivalent, the accounts receivable are assets.
Understanding the difference between assets and liabilities is foundational in finance. Accounts receivable, being amounts owed to a business, are firmly in the asset category. Always remember, if someone owes you money, it’s an asset to you. On the flip side, if you owe someone, it’s a liability.
While accounts receivable are undoubtedly assets, managing them effectively requires vigilance. Let’s consider three pitfalls related to accounts receivable that you should watch out for.
One of the most common pitfalls associated with accounts receivable is allowing them to age for an extended period. An “aging receivable” refers to money owed to a business that remains unpaid beyond the stipulated payment terms. The older a receivable gets, the harder it might become to collect. Over time, the likelihood of default (non-payment) can increase. You should routinely review an aging report, which categorizes receivables based on the length of time they have been outstanding. This allows you to focus your collection efforts on overdue accounts and potentially write off uncollectible amounts.
Inadequate Allowance for Doubtful Accounts
Not all accounts receivable will translate into cash. There will invariably be some customers who don’t pay, whether due to financial difficulties, disputes over the product or service, or other reasons. Businesses need to set up an allowance for doubtful accounts – a contra-asset account that reduces the total accounts receivable to an amount that is expected to be collected. Underestimating this allowance can lead to inflated assets and unexpected hits to the income statement when accounts are ultimately written off.
Lax Credit Policies
While extending credit can boost sales, having overly lenient credit policies can lead to a surge in accounts receivable. If a business doesn’t have a rigorous process for evaluating the creditworthiness of its customers, it might end up selling to those with a high risk of default.
To help mitigate potential losses and manage accounts receivable more effectively:
- Implement a robust credit assessment process,
- Set clear credit limits, and
- Regularly review customer creditworthiness.
In essence, while accounts receivable represent expected cash inflows and are assets, it’s crucial to manage them with care. Being proactive, regularly reviewing receivables, and establishing clear credit policies can help you avoid these pitfalls and ensure that your accounts receivable remain valuable assets.
If accounts receivable are a challenge for your company, give us a call. We specialize in bookkeeping technology solutions to help you keep a finger on the pulse of your business.