Customer Accounts on the Financial Statement
Accounts receivable, also known as “receivables” or “A/R,” are the money owed to a company by its customers. If the company has provided products or services and has not yet received payment, it is considered an account receivable.
The nature of a company’s accounts receivable balance depends on the industry in which it operates, as well as the credit policies followed by corporate management. The company tracks accounts receivable as current assets on what is called the “financial statement.” Among other values, the financial statement includes the amount of money the company expects to receive (as assets) and the amount it expects to pay (as liabilities). Understanding accounts receivable is important in assessing the overall health of the company.
Importance of Payment Terms
The company selling products on credit, that is, before receiving payment, sets terms for accounts receivable. These terms include the number of days customers have to pay their invoices before they incur late fees. When a buyer does not adhere to the payment terms, the seller may reach out to the customer and offer new terms or alternative solutions for collecting the invoice.
If no progress occurs, the accounts receivable balance may be transferred to a debt collection agency, or in more extreme cases, the company may sue the debtor to seek compensation through asset seizure.
Companies often use one of several well-known accounts receivable terms. These terms are expressed as “Net 10,” “Net 15,” “Net 30,” “Net 60,” or “Net 90.” The numbers refer to the number of days by which the net amount expected to be paid should be settled. For example, if the sale is net 10, you have 10 days from the invoice date to pay your balance.
To free up cash flow and increase access to funds, many companies offer an early payment discount on longer accounts receivable to try to convince their customers to pay earlier.
Large Accounts Receivable Balances Can Be Risky
Having a large amount due on the financial statement may seem attractive. You might think that every company desires a future cash flow, but this is not always the case. The money in accounts receivable is money that is not in the bank, and it can expose the company to a degree of risk. If Walmart were to go bankrupt or simply not pay, the seller would have to write off the $1.5 million accounts receivable balance on the financial statement.
Taking this loss and the inability to sell 50,000 units of dedicated books could be catastrophic for the seller. If you are considering the future growth prospects of a company, make sure to look at its accounts receivable book. It should be well diversified.
Note: If any customer represents more than 5% or 10% of accounts receivable, there may be an exposure that could be a cause for concern.
Companies build cash reserves to prepare for issues like these. Reserves are a specific accounting charge that reduces profits annually. If reserves are insufficient or need to be increased, further charges must be made on the company’s income statement. Reserves are used to cover all kinds of problems, from anticipated warranty returns to bad loan recoveries in banks.
An Alternative to Accounts Receivable
Some companies rely on a different business model and insist on receiving payment upfront. In this case, the company does not record an accounts receivable transaction but enters a liability on its balance sheet into an account known as unearned revenue or deferred revenue.
When
Money is earned, whether through the billing of promised products, by using the “percentage of completion” method, or simply over time as it is transferred from unearned revenue on the balance sheet to sales revenue on the income statement. This reduces liabilities and increases reported revenue.
A good place to consider this is in the asset management industry. Clients often pay a registered investment advisor fees every four months, billed in advance. The advisory firm receives the cash but has not yet earned it. For each passing business day, a certain amount of the fees becomes earned and non-refundable.
On the other hand, an asset management company that opts for later billing has an accounts receivable on its balance sheet, usually for just two days as the fees are deducted from clients’ deposit accounts.
Frequently Asked Questions (FAQs)
What is the accounts receivable turnover ratio?
The accounts receivable turnover ratio is a measure that shows how efficiently a company is collecting its debts. It divides the company’s credit sales for a certain period by the average accounts receivable during the same period. It shows how many times the company collects its average accounts receivable during that period. The lower the number, the less efficient the company is at collecting debts.
How does collecting cash affect the balance sheet?
When you collect cash against an accounts receivable balance, the company is converting the balance from one current asset to another. The accounts receivable balance decreases while the cash balance increases. Liabilities and equity remain unchanged.
How do accounts receivable affect cash flow?
By their nature, accounts receivable delay cash payments from customers, negatively impacting short-term cash flow. The higher the accounts receivable balance a company has, the less cash it realizes from sales activities. For this reason, it is important for companies that use accounts receivable to monitor turnover ratios and be proactive with customers to ensure timely payments.
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Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and high quality.
Financial Review Office of the Texas Department of Finance. “Accounts Receivable.”
Arizona Financial Information System. “Billing and Collections Training Guide for Accounts Receivable.”
B&C Financial Advisors. “B&C Management Fees Report.”
Timmons Wealth Management. “Our Fees.”
Brighton Financial Planning. “Fee Schedule.”
Source: https://www.thebalancemoney.com/accounts-receivables-on-the-balance-sheet-357263
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