What is Accounts Receivable in accounting? How are accounts receivable classified, recognised, measured, and presented on the financial statements, and what are the main accounting journals for sales and receipts from debtors.
What is accounts receivable in accounting?
Accounts receivable or similarly named trade receivable represent the money that your customers or clients owe to the company for the services or products they have bought on credit.
The Accounts Receivables are presented as a current asset on the Balance Sheet and are due to be received within one year or one accounting period. Therefore, the accounts receivable is considered as working capital.
In most of the cases accounts receivable arises due to companies that allow sales on credit as an incentive to customers or clients to try them products and serviced with the aim to get loyal customers or clients on the long term. At the same time the sales on credit will increase the revenue and improve company ratios overall.
Another reason for companies to sell on credit, could be just due to technical aspects of the product or services as might be unfitted to deliver the products or services at the same time with the sale. Therefore, the buyers much pay once the products are physically received or in terms of services once the services are effectively used.
Account receivables make a big impact of the company wealth as they are related directly to the company revenue and liquidity at the same time. Therefore, the terms agreed, and receivable collection periods will be an important factor for the company liquidity and any changes will be reflected within cash flow from where the company stakeholders can extract, analyse and asses the company health.
What is accounts receivable turnover ratio?
A common tool to analyse the accounts receivable and company financial health, is the Accounts Receivable Turnover Ratio that will measure the number of times over a given period that a company collects its average accounts receivable and is calculated as below:
Accounts receivable turnover ratio = Net credit sales ÷ Average accounts receivable
- Net credit sales are the sales where the receivables are collected later and are calculated as per the formula below:
Net credit sales = Sales on credit – Sales returns – Sales allowances.
- Average accounts receivable is the sum of opening and closing accounts receivable balance over a period divided by two, and are calculated as per the formula below:
Average accounts receivable = (Opening balance + Closing balance) ÷ 2
The use of Accounts Receivable Turnover Ratio is vey important to establish a company financial performance and is used by many stakeholders i.e. management, investors, or lenders.
When analysing the Accounts Receivable Turnover Ratio and there is a high ratio will be an indication of efficiencies in the company collection process that result in a better liquidity and financial health of the company. At the same time a high receivable turnover can happen when the companies give shorter periods of credit to them customers and clients that result in quicker collections of receivables within the analysed period.
In addition, a high Accounts Receivable Turnover Ratio show that the company have great products and services that are in high demand and sell faster.
When there is a low Accounts Receivable Turnover Ratio could mean that the company incur some inefficiencies within the receivable collection process that can happen either due to company terms and conditions, hard to sale products or services, or financial difficulties of the customers or clients.
In addition, a low Accounts Receivable Turnover Ratio show hat the company have products and services that are not in high demand and sell slow.
Either if there is a low or a high Accounts, Receivable Turnover Ratio the companies should analyse and assess the performance in comparation with the competition. This way the company will have a more realistic picture about the company performance within a specific market.
What is the accounts receivable A/R aging report?
Another tool to analyse the accounts receivable a company financial health is the A/R aging report that breaks down the company outstanding invoices by how old they are, and group them usually in brackets of 30 days i.e. 0-30 days, 31-60 days, 61-90 days, and over 90 days.
From the A/R aging report the entity stakeholders can extract the data and an analyse if the collection periods are kept under the control and time frame agreed with the customer and clients and how efficient the company is collecting the receivables balances.
The A/R aging report will give a breakdown of the outstanding receivables per customer or client that can show which accounts receivables collected earlier or later in comparation to the terms and conditions agreed with the customers and clients.
At the same time the A/R aging report is a useful tool for the business to track and analyse the outstanding accounts receivable and see where better receivable collection policies are required with the aim to maintain a healthy cash flow and liquidity for the business.
What is accounts receivable Days Sale Outstanding (DSO) formula?
Accounts receivables are directly related to the revenue and is an important indicator on the performance and financial health of the company.
The main formula a company can use to analyse the long it takes for the customers and client to settle the balances they owe to the company is Days Sale Outstanding formula as you can see below:
Days Sales Outstanding (DSO) = (Average Accounts Receivable ÷ Revenue) × 365 Days
Earlier settlements of account receivables could mean that the company collection policies are strong, or the customers and suppliers are reliable, have a good relationship with the company, the products and services are on high demand, and the customers and clients pay what they owe in time or earlier.
On the other side, whereas accounts receivable is outstanding and get over the term agreed means the collection policies are poor, or the customers and suppliers might have financial difficulties, the products and services are selling slow, therefore the customers and clients pay what they owe latter that required as per the terms and conditions agreed.
What are the main responsibilities of accounts receivable department?
Accounts receivables can refer as well as the department within a company responsible with managing sales, recording the invoices and lodging the payments received from customers and clients and other functions in relation to the management of sales and receivables as the company would require.
Thee accounts receivables processing can be done manually or automated with the use of accounts receivable software, and the main functions of account receivable are described below:
- Creating the terms and conditions for sales on credit.
- Managing sales and invoicing.
- Assessing the customers credit eligibility.
- Performing sales and receipts reconciliation.
- Dealing with unpaid Invoices.
- Customers/clients relationships management.
- Reporting and ratio analysis.
Creating the terms and conditions for sales on credit.
The accounts receivable department in junction with the higher management and company goals could contribute for the creating the terms and conditions for sales on credit to customers and suppliers.
The term and condition sales on credit agreements (contracts) will include any special conditions agreed in writing between the seller and the buyer. The main areas covered by the sales on credit agreements (contracts) will be the eligibility requirements form the customers/clients, the basis of sales, the price off the products or services, discounts allowed terms for settlements, general formal terms, and any other terms and conditions that the company will find useful for keeping a good relationship with the customers or clients, increase sales and collection times at the same time while keeping a healthy cash flow.
Managing sales and invoicing.
The account receivable department will be in close relationship with the sales team, and keep it informed about the sales and customers/clients. The accounts receivable department can provide meaningful reports about the sales amounts per customer/client or debt collection analytics that will be handful tolls for the sales team in the relation to the customers/clients.
On the other side the sales team is providing with the invoices for processing and other information required for the accounts receivable department in relation to the customers or clients.
Some of the information required to keep the accounts receivable ledgers and sales systems accurate and up to date for a good tracking of invoices and collection ratios are the invoice date, invoice number, buyer details, contact details, terms agreed, prices, discounts allowed.
Assessing the customers credit eligibility.
While there are many potential buyers that are willing to buy on credit terms, the company must be aware that some of the potential buyers might have a high risk in terms of the ability to settle the debts in a timely manner. At the same time the company might not want to sale on credit for new and unknown customers/clients before a time-based good relationship has been created.
On the other side the terms and conditions for sales on credit must take in consideration the company resources available to sustain the liquidity and a healthy cash flow.
Therefore, taking in consideration a set of requirements in relation to the company resources and aversions to risk the accounts receivable department could release a set of rules assigned to the terms and conditions for the sales on credit in rapport to the requirement for the customers credit eligibility criteria.
The companies can use many ways to assess the customers credit eligibility, and some of the most used are by running a credit check, monitor the past information for established clients, asking for an up-to-date financial standing report, or checking the customer/client references.
Assessing the customers credit eligibility can be performed by the accounts receivable department for new or established customers and revised periodically to make sure the terms and conditions are still meet by the customers and at the same time still apply to the company performance requirements.
Performing sales and receipts reconciliation.
One of the main accounts receivable department responsibilities are to perform sales and receipts reconciliation to assure the receivable ledgers are accurate and up to date.
Some of the key functions that are preformed by the accounts receivable department are matching the payments received to the open invoices and reconciling the sales ledger to the receipts up to date.
When matching the open invoices to payments the accounts receivable department should perform the allocation the payments received to the corresponding invoice based on the information stored within the customer ledger i.e. customer, due date, amount receive to the amount as per invoices, invoice and payment references.
On a periodical basis either daily, weekly monthly or annually as per the requirements set by the company the accounts receivable department should perform sales to receipts reconciliations, to assess the accuracy of the receivable’s ledger data, and at the same time to analyse the due invoices and if the terms and conditions for the sales on credit are respected by the customers/clients.
Dealing with unpaid invoices.
Following the reconciliations and strictly monitoring of the accounts receivables, the company can assess what accounts are late to be settled and actions should be performed for an earliest settlement. The accounts receivable department can deal with such a mater by issuing reminders and notification letters to debtors, passing the debts to agencies specialized in debt collection, initiating and following legal procedures to recover the amounts due, or ultimately to write off the accounts not recoverable.
At the same time the accounts receivables department have all the data based on previous debtors’ history that can be used to assess the potential of uncoverable amount in the future and can estimate the accruals for the bad debts at the end of the financial period.
Customers/clients relationships management.
Accounts receivables department and sales team are the main contact to the company customers or clients. Even the Accounts receivables department staff might not be facing directly the customers or clients as a salesperson, still there is a great responsibility in the hands of the accounts receivables department as most of the time working interchangeably with the sales team.
Therefore, the accounts receivables department shall always take a constructive relationship approach when sending reminders and notifications for late payments or renegotiating the terms and conditions for difficult customers or clients. At the same time, they must keep the sales team informed about late debtor’s accounts or changes of the terms and conditions.
Reporting and ratio analysis.
The accounts receivable is recording and keeping all the data in relation to the company debtors that can be extracted for analytics and assessments of the company financial health, and reporting to different stakeholders.
This data can be converted in meaningful reports as Aging Reports, Receivable Turnover Ratio, and Days Sale Outstanding (DSO). These are important and useful reports for the company decision persons and a real aid in planning and decision making to achieve the company objectives. Beside the company decision persons, the accounts receivable reports are often requirements by other stakeholders as states departments, lenders and so on.
The accounts receivable department should always keep an accurate and up to date data that can be easily available once requested.
What are the main types of receivables?
Accounts receivables are in most cases presented int the accounts and financial statements in trade accounts receivable, notes receivable, and other accounts receivable.
Accounts Receivable
Accounts receivable are the most popular receivables that arise from the sales on credit terms and conditions to customers or clients. Usually, the accounts receivables terms for settlement are short with the range between one to three months.
Notes Receivable
Notes Receivable comes in a physical form of a formal loan letter. These accounts receivables usually extend for a longer period that could range between 3 to 12 months. The notes receivable letters have some interest receivable attached to them that can incur upon a granted free interest period as per the terms and conditions agreed between the company with the customers or clients.
Other Receivables
As the title describes these can be any other receivables that the company is expected and can not be classified under the Accounts Receivables or Notes Receivables within the accounts and financial statements.
How to apply IFRS 9 – Financial Instruments to accounts receivables impairment?
IFRS 9 introduces a new impairment model based on expected credit losses for debt instruments such as debt securities, loans, and trade receivables. However, for trade receivables is used a simplified approach as summarized below.
As mentioned above the IFRS 9 – Financial Instruments for trade receivables is using a simplified approach with the main approach for the credit loss allowance to not be taken in consideration on the initial recognition. Therefore, the loss allowances will be calculated as the present value of the expected cash flow reductions over the remaining life of the accounts receivables balances.
In other words, this approach uses a matrix model method made of historically observed default rates adjusted for future estimates.
How to apply the International Accounting Standard (IAS 17) for the lease receivable?
As per the International Accounting Standard IAS 17 – Leases the classification of leases requires is either as finance leases which transfer substantially all the risks and rewards of ownership, therefore, giving rise to a receivable recognition by the lessor, or operating leases with the lease recognised as an asset by the lessor.
Therefore, at commencement of the lease term the lessor should record a finance lease in the Statement of Financial Position (Balance Sheet) as a receivable.
How to account and what are the main journal entries for accounts receivable?
As with any other transaction the accounting systems should use the double entre bookkeeping those records two journal entries for each transaction in relation to the accounts receivable. Some examples of the main journal entries a company use to record within the accounts receivable ledgers are listed below:
Double entry accounting journals for recording the sale of goods on credit.
- Debit (DR: Statement of Financial Position (Balance Sheet) – Accounts Receivable
- Credit (CR): Income Statement (Profit & Loss) – Sales Revenue
Double entry accounting journals for recording the receipts from the sale of goods on credit.
- Credit (CR): Statement of Financial Position (Balance Sheet) – Accounts Receivable
- Debit (DR): Statement of Financial Position (Balance Sheet) – Cash
Sometimes the companies are looking to increase the revenue or the collection time and can offer incentives to the buyers in term of discounts allowed. There are two types of discounts (Trade discounts and cash discounts) that a company can give to the buyers as described below:
Trade Discounts
The trade discounts are usually given to increase the sales and improve the relationship with the buyers. The trade discounts are reflected as a reduction in list price for the discounts allowed by the company to the buyer usually for bulk purchases. Within the accounts receivable ledgers, the sales shows as net of trade discounts.
Cash discounts
The cash discount is usually given as an incentive to the debtor to settle the outstanding bills in time or earlier. When cash discounts are given the sales are invoiced at the full amount and the receivables are reduced by the amount of discount agreed.
Double entry accounting journals for recording the sales of goods on credit when a trade discount was allowed.
- Debit (DR: Statement of Financial Position (Balance Sheet) – Accounts Receivable (Full amount)
- Credit (CR): Income Statement (Profit & Loss) – Sales Revenue (Full amount)
Double entry accounting journals for recording the receipts from the sale of goods on credit when a cash discount was allowed.
- Credit (CR): Statement of Financial Position (Balance Sheet) – Accounts Receivable (Full amount)
- Debit (DR): Statement of Financial Position (Balance Sheet) – Cash
- Debit (DR): Income Statement (Profit & Loss) – Discount Allowed
Conclusion
Accounts receivable management is important for the entities to track the debtors, manage cash flow, keep accurate records with relevant data that can be easily pulled in meaningful reports for the company decision makers or the use of third-party stakeholders.
By keeping accurate records, the company can rest assured that the statement reflects a real picture about the company. At the same time my monitoring the account receivable the company can assess the accounts paid in time or the accounts overdue and take better decisions in relation to the cash flow management.
In addition, having access at all the customers or client data the accounts receivable is an important tool to track the debtors’ behaviours, as based on past information to improve the term and conditions for sales on credit while improving the overall financial position of the company.
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