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Accounts Receivable and Receivables
Definitions, Meaning Explained, Example Transactions

 

An account receivable is money owed to a seller for a purchase, where goods or services have been delivered but not yet paid for. When the buyer actually makes cash payment, the seller marks the customer invoice "Paid in Full."

Is the firm's collection process effective and efficient? The Accounts Receivable Turnover metric provides an answer.

What Are Receivables and Accounts Receivable?

The term receivable refers to money owed to a firm that meets two requirements:

Firstly, the money is legally owed to the firm.

Secondly, the firm has good reason to believe it will actually receive the funds.

The firm may expect the funds either in the short term, as with "Accounts receivable," or in the long term, as with "Long term notes receivable."

When a customer buys goods or services using seller-provided credit, the customer becomes an account receivable for the seller. As a result, seller and buyer have a creditor-debtor relationship that remains until the buyer actually makes cash payment. During the life of the debt, however, the amount due contributes to an asset account in the seller's accounting system, "Accounts receivable." The seller's Accounts receivable balance is the sum of all such debt currently owed the seller, with payoff due in the near term.

Receivables Help Define Financial Position and Financial Performance

Firms that use double entry accrual accounting carry receivables as assets on the Balance sheet. As a result, the firm's receivables balance contributes to financial position metrics that involve asset accounts. The following metrics all reflect the receivables balance:

Working Capital
Current ratio
Quick Ratio - Acid Test Ratio
Return on Capital Employed ROCE
Return on Total Assets ROA
Accounts Receivable Turnover

Sections below illustrate the role of receivables in these metrics.

Note also that receivables also impact measures of financial performance, such as margins and profits. Creating a receivable from trade activities, for instance, results in two accounting system entries.

  • Firstly, a debit (increase) to a receivable asset account, such as "Accounts receivable."
  • Secondly, a credit (increase) to a revenue account, such as "Sales revenues."

In other words, the seller registers revenue earned as soon as the Account receivable is created. Increasing revenues, of course, improves margins and profits.

Explaining Receivables in Context

This article further explains receivables and their role in financial accounting, financial metrics, and financial analysis. Sections below explain these concepts in context with related terms, including the following.

Receivables
Accounts Receivable
Accounts Payable
Short Term Receivables
Long Term Receivables
Accrual Accounting
Chart of Accounts
Doubtful Accounts
Notes Receivable
Trade Receivables
Interest Receivable
Loan Receivables
Cash Basis Accounting
Hybrid Accounting
Modified Accrual Accounting

 

Contents

Related Topics

 

Define Your Term!
Basic Receivables Concepts and Definitions

Basic receivables terms are defined as follows:

Receivables

The term receivables itself refers simply to financial obligations legally owed to firm, which the firm has good reason to expect it will actually receive.

Short Term Receivables

Short term receivables are funds due for receipt in the short term, which usually means one year or less. These receivables, such as "Accounts receivable," appear under Current assets on the Balance sheet.

Long Term Receivables

These receivables are funds due in the long term, which usually means one year or more. Firms carry long term receivables such as "Long term notes receivable" on the Balance sheet under a Long term assets category.

Account Receivable

An account receivable is a sum owed to a seller by a customer, after the seller delivers goods or services, but before the customer actually pays.

For example, a customer orders goods from a seller, who ships the goods immediately. At the same time, the seller sends the customer an invoice stating "Net 30." This means the payment is due in 30 days or less. Until the customer actually pays, the seller carries the sale amount as an Account receivable.

Accounts Receivable

For sellers using accrual accounting, Accounts receivable is an asset-category account in the accounting system chart of accounts. For sellers who deliver goods or services first, and invoice customers for payment later, the Accounts receivable balance is the total due in the near term from all customers.

Net Accounts Receivable and Allowance for Doubtful Accounts

The term Net accounts receivable sometimes appears on the Balance sheet as the difference between two other listed accounts:

Net accounts receivable = 
       Accounts receivable 
           – Allowance for doubtful accounts

In the interest of accounting accuracy, firms use "Allowance for doubtful accounts" in this way to signal they now believe they will never receive payment for certain receivables. Examples below show that financial metrics involving receivables (such as Working capital) should use the "Net" figure, when provided, instead of "Accounts receivable."

Notes Receivable

These receivables are debts owed to the company by customers or others who acknowledge their debts by signing promissory notes.

  • Notes receivable, short term are notes due in the short term, usually one year or less. Firms carry these on the Balance sheet as Current assets.
  • Notes receivable, long term are notes due some time in the more distant future, usually one year or more. Firms carry these on the Balance sheet as Long term assets.

Loan Receivables

Loan receivables is a Balance sheet term used primarily by lending institutions such as banks. The term refers to expected loan repayments by the bank's debtors. Note, however that some banks and lenders simply report these receivables instead as "Accounts receivable."

Trade Receivables

Trade receivables is a term that refers to both (a) Accounts receivable and (b) Notes receivable that result from trade activities. And, the term Non-trade receivables refers, not surprisingly, to receivables that do not result from sales or trade activities.

Interest Receivable

Interest receivable refers to interest revenues the firm has earned, but not yet received. These receivables are due to notes, loans, or other interest-bearing debt the firm issues.

Other Receivables

Other receivables is a Balance sheet "catch all" category for monies owed to the firm that qualify as receivables, but which do not conform to any other receivables definitions above.

Who Uses Accounts Receivable and Other Kinds of Receivables?

Strictly speaking, the receivables concept is possible only under an accrual accounting system. This is because accrual accounting applies two basic principles:

  • Firstly, recording revenues when they are earned (by delivering goods and services).
  • Secondly, recording expenses when they are owed.

Public companies, everywhere, must report to shareholders, regulators, and tax authorities, in conformance with the country's Generally Accepted Accounting Principles (GAAP). For businesses, this almost always calls for accrual accounting. For firms that sell goods or services, the most prominent receivable category on the Balance sheet is, not surprisingly, Accounts receivable. However, the other kinds of receivables are also possible for an accrual-based company.

Receivables Under Cash Basis Accounting.

Very few firms in business use the primary alternative to accrual accounting, cash basis accounting. Firms that do use cash basis accounting record revenues only when they receive cash payment. And, they record expenses only they pay them. Under the strict form of cash basis accounting, therefore, Accounts receivable and other kinds of receivables, simply do not exist. That is, they do not exist as formal accounting concepts.

This does not mean, however, that cash-basis firms must refuse to "sell on credit." Nor does it mean that cash-basis firms simply lose track of monies owed them.

  • Privately held companies, government organizations, and non-profit entities that do not have to report in compliance with business-GAAP requirements, can report and manage using so-called hybrid accounting, modified cash basis accounting, or modified accrual accounting systems. These three terms are essentially interchangeable.

    Such approaches can be set up to record revenues when they are received (as in cash accounting), but record expenses when they are owed (as in accrual accounting). Or, alternatively, they can do be set up to do the reverse: record revenues when they are earned, but record expenses only when paid.
  • Entities reporting under strict cash basis accounting can still create "receivables" accounts to keep track of monies legally owed them. They use transactions and balances in these accounts for planning, billing, and budgeting purposes. For the cash-basis firm, however, these accounts do not appear in financial reports.

Receivables in Reporting and Analysis
Balance Sheet Example

At the end of a reporting period, receivables appear on the Balance sheet as Exhibit 1 shows.

Grande Corporation                                   Figures in $1,000's
Balance Sheet at 31 December 20YY   
ASSETS
Current Assets
   Cash
   Short term investments
   Accounts Receivable
      Less allowance doubtful accts
      Net accounts receivable
   Notes receivable short term
   Inventories
      Raw materials
      Work in progress
      Finished goods/merchandise
      Operating & office supplies
            Total Inventories
   Prepaid exp, insurance, def taxes
          Total Current Assets




1,969
   137



    611
1,692
3,664
      19


1,369
  137


1,832
     20





5,986
  265
















9,609
Long Term Assets
   Long Term Investments & Funds
   Property, Plant & Equipment
   Other Assets
          Total Long Term Assets
     
1,460
  9,716
       68




11,224
Intangible Assets
     1,222
                    Total Assets      22,075
LIABILITIES
    Current Liabilities
    Long Term Liabilities
          Total Liabilities


3,464
 5,474



8,938
OWNERS EQUITY
   Contributed capital
   Retained earnings
          Total Owners Equity
 
9,439
 3,698



13,137
          Total Liabilities & Equities     22,075
 

Exhibit 1. Example Balance sheet showing both Short term receivables and Long term receivables..

  • Short term receivables accounts (including Accounts receivable and short term notes receivable) appear as line items on the Balance sheet under Current assets
  • Long term receivables appear after all Current assets, listed instead with a name that includes "Long term." The example above, for instance, isLong term investments & funds.

Note that Net accounts receivable is more appropriate than Accounts receivable for use in the financial metrics below.

On the Balance sheet, an "Allowance for doubtful accounts" recognizes the reality that some of these receivables will never be received. A seller might decide that a debt will never be paid, for instance, because the customer has gone out of business. As the example shows, Net accounts receivable is the Accounts receivable balance less Allowance for Doubtful accounts.

Five Financial Metrics Measure Receivables Performance

As Current assets, Accounts receivable and other short term receivables contribute to measures of the organization's liquidity, such as Working capital, the Current ratio, and the Acid test (Quick ratio). Receivables also contribute to quite a few other metrics, including efficiency metrics such as Accounts receivable turnover, and profitability metrics such as Return on assets (ROA).

The examples below show how to calculate and interpret liquidity, activity, and profitability metrics that include receivables. The examples use figures from the Balance sheet in Exhibit 1, above.

Recivables Performance Metric 1
Working Capital With Receivables

Working capital is a measure of liquidity, stated as in currency units. A firm's working capital is simply the difference between its Current assets and its Current liabilities.

Working capital =
     Current assets – Current liabilities
             =  $9,609,000 – $3,464,000
                    = $6,145,000

Note that "Current assets" includes Net accounts receivable of $1,832,000 and Short term notes receivable of 20,000. Without short term receivables, the company's working capital would be 4,295, 000.

In any case, management will respond to such figures by asking: Is this enough working capital? They will try to answer this question by estimating short term liabilities, cash inflows, and short term receivables for the next year.

Recivables Performance Metric 2
Current Ratiol With Receivables

A company's Current ratio is another liquidity metric built from the same Balance sheet figures that go into the working capital calculation. Instead of showing a difference, however, the Current ratio is—no surprise—a ratio: Current assets divided by Current liabilities.

Current ratio =
     Current assets / Current liabilities
             =  $9,609,000 / $3,464,000
             = 2.77

Without short term receivables, the company's current ratio would instead be 2.32. In any case, analysts typically refer to a current ratio of 2.0 as a "rule of thumb" minimum for healthy liquidity. On the other hand, a current ratio under 1.0 (or a negative working capital) is a cause for alarm.

Receivables Performance Metric 3
Quick Ratio/Acid Test With Receivables

The Quick ratio, or Acid-test ratio is a more severe liquidity test. This metric is similar to the current ratio, except that Inventories are subtracted from Current assets before calculating the ratio. Removing Inventories from Current assets provides a more severe liquidity test because Inventories are the least liquid Current assets components:

Quick ratio =
   (Current assets – Inventories) / (Current liabilities) 
        = ($9,609,000 –  $5,986,000)  /  $3,464,000
        = 1.04

Whereas this company's Current ratio looked strong enough, the Acid-test ratio might be cause for concern. Analysts generally consider an Acid-test ratio of about 1.1 as a minimum healthy level. The same ratio without short term receivables in Current assets would be even more alarming: 0.511.

Receivables Performance Metric 4
Accounts Receivable Turnover

The Accounts receivable turnover metric measures the firm's operational efficiency, or productivity, in earning from its assets. In this case, the assets in view are Accounts receivable. Assets that take longer to turn over are considered less productive than those that turn over quickly.

Accounts receivable turnover is the ratio of Net sales revenues (from the Income statement) divided by Accounts receivable (from the Balance sheet). For this example, assume that the firm reports Net sales revenues of $32,983,000. Using the Net accounts receivable figure $1,832,000 from Exhibit 1, the turnover metric is therefore: 

Accounts receivable turnover =
      Net sales revenues / Net accounts receivable
          = $32,983,000 / $1,832,000
          = 18.0

This firm achieves 18.0 "Accounts receivables turns" for the year. A turns rate of 12 or more shows that, on average, the firm collects Accounts receivable in one month or less.

  • If the receivables turn rate is in accord with its payment terms, the firm's collection performance seems healthy.
  • However, the opposite conclusion follows if the receivables turn rate shows average collection times much longer than stated payment terms.
    • This could be a signal that the firm is accepting business from customers who are poor credit risks.
    • Or, a very low turns rate may also mean that the firm has to negotiate very long payment terms in order to win sales.

Receivables Performance Metric 5
Return on Total Assets

Profitability metrics measures a firm's ability to earn from its asset base. Receivables—because they are Balance sheet assets—contribute to several profitability metrics, including Return on total assets (ROA), Return on capital employed (ROCE) and Return on equity (ROE). The importance of the receivables contribution to these metrics depends, of course, on the relative size of the receivables component in the organization's asset structure.

A Return on total assets (ROA) example appears below. For ROE and ROCE examples, please see the article Profitability.

Return on total assets is simply Net income divided by Total assets. For this example, assume that the firm's Income statement shows Net income of $2,126,000 for the year. Assume also that the end-of-period Balance sheet (Exhibit 1) reports Total assets of $22,075,000. ROA, therefore, is:

ROA  = (Net income) / (Total assets)
          =  $2,126,000 / $22,075,000  = 9.6%

Note that the contribution of Accounts receivable to this ratio is complicated. This is because a change in the Accounts receivable figure impacts both the numerator and denominator of the ROA ratio. Decreasing Accounts receivable, for instance, lowers the Total assets figure, of course. However, the same decrease also implies that sales revenues also decrease.

In any case, company managers and owners will compare the firm's ROA with other firms in the same industry. And, they will look for year-to-year trends in the firm's ROA.

Working Capital With Receivables

In an accrual accounting system, receivables can appear in quite a few different kinds of transactions. Because firms carry receivables in asset category accounts, debit and credit actions have the following impacts:

  • Asset account balance increases with a debit entry.
  • Asset account balance decrease with a credit entry.

In double entry accounting, however, an entry in a receivables asset account can also call for a corresponding debit or credit in another account in any of the five account categories—assets, liabilities, equities, revenues, or expenses.

Below are just a few basic examples of debits and credits that result from creating a receivable.

First Example: Creating the Receivable

Consider, for example, a manufacturer selling goods to another company. On 20 September, Grand Corporation sells and delivers a product purchase to the buyer, Mercury Corporation. At the same time, Grande Corporation sends Mercury an invoice for $84,400. The invoice states "Net 30," meaning that Mercury must pay Grande Corporation in 30 days or less.

At sale closing, a Grande bookkeeper recognizes the sale with two journal entries such as these:

Grande Corporation
Journal for Fiscal Year 20YY
Date Account Debit
Credit
20-Sep-20YY
20-Sep-20YY
 NNN  Accounts receivable
 NNN      Sales revenues
$84,400  
$84,400

The sale to Mercury becomes an Account receivable for Grande Corporation. As a result, Grande's Accounts receivable account balance increases by (is debited for) $84,400. Grande also claims sales revenues at this time by simultaneously increasing (crediting) its Sales revenues account by the same $84,400.

The receivable now exists and sales revenues are now "on the books," even though Mercury has not yet paid.

While the bill is unpaid, Grande and Mercury have a creditor-debtor relationship. The seller (Grande) carries another $84,400 in its own Accounts receivable account, while the buyer (Mercury) adds (credits) $84,400 to its own Accounts payable account, a liability account.

Second Example: The Customer Finally Pays in Cash

What happens next depends on whether or not Mercury actually pays Grande Corporation. If Mercury pays in cash within 30 days or less, say on 15 October, Grande Corporation (the seller) preserves $84,400 in sale value by moving that sum out of Accounts receivable and into another asset account, Cash.

Grande Corporation
Journal for Fiscal Year 20YY
Date Account Debit
Credit
15-Oct-20YY
15-Oct-20YY
 NNN  Cash
 NNN      Accounts receivable
$84,400  
$84,400

Double entry bookkeeping and accrual accounting have kept the sale on the books while Grande waits for Mercury's payment. With payment, Cash increases by $84,400 while Accounts receivable is decreases by the same amount.

Third Example: Customer Goes Bankrupt Instead and Does Not Pay

Assume now, however, that instead of paying its debt, Mercury goes into bankruptcy and becomes unable to pay. Furthermore, Mercury's liquidator lets Grande know that asset liquidation will not generate funds enough to pay the debt. Grande knows now that the Mercury will never pay the $84,400 debt.

In that case, Grande Corporation can write off the debt by increasing two accounts by $84,400: Bad debt expense and an Allowance for doubtful accounts.

Grande Corporation
Journal for Fiscal Year 20YY
Date Account Debit
Credit
15-Nov-20YY
15-Nov-20YY
 NNN  Bad debt expense
 NNN       Allowance for doubtful accounts
$84,400  
$84,400

Here, a $84,400 increase to Bad debt expense (an expense account) pairs with an $84,400 increase to Allowance for doubtful accounts. The "Allowance" account is an asset category account, but it is also a contra asset account, meaning that  "Allowance for doubtful accounts" increases with a credit transaction (opposite to the credit impact on a normal asset account).

The Full Accounts Receivable Story

The Balance sheet example above shows one way the "Accounts receivable story" can end. In Exhibit 1, Accounts receivable has a balance of $1,969,000. This figure still includes the $84,400 sale value to Mercury. However, the Allowance for doubtful accounts line also appears, in this case with a balance of $137,000. Mercury's bad debt accounts for $84,000 of this. Note especially that "Net accounts receivable is the Accounts receivable figure less Allowance for doubtful accounts.

Other ways to dispose of the asset value involve crediting (decreasing) the Accounts receivable account before it gets to the Balance sheet. Either approach is legal and supported by GAAP. However, many people in business prefer showing the mathematics on the Balance sheet, in the interest of full transparency for regulators, investors, and tax authorities.

Note, finally, that disposing of the Account receivable does not impact the Sales revenues report on the Income statement. Sales revenues earned, after all, do not diminish simply because the customer fails to pay.

However, notice the above journal entry debiting (adding to) Bad debt expense. On the Income statement, the firm subtracts bad debt expense from revenues before reaching Operating profit and Net profit. The firm now reports profits correctly for the revenues it actually receives.

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