The majority of the businesses sell their offerings on credit. Say you run an advertising agency or another creative service industry in the United States. In that case, you must have often delivered your services to customers in Period A and received payments in Period B.
This balance due, in a formal expression, is called Accounts Receivable (AR).
This comprehensive blog walks you through the journey of AR - right from its meaning to application, repercussions, examples, and ways to use it to settle your outstandings.
AR is essentially the amount of money earned from your customers but not received in your bank account. Organizations usually offer credit periods for customers as a sign of assistance.
AR is registered as a current asset in the balance sheet and is applicable under the accrual method of accounting.
As the names suggest, Accounts Receivable (AR) is your organization's asset, representing the money that you will receive in the future. Accounts Payable (AP) is your balance sheet liability that symbolizes the money you owe to other entities.
For example, you managed your client's social media account for a quarter. At the end of the contract, you issued an invoice for your rendered services. This invoice, which is an AR for you, is an AP for your client.
AR and AP are in sharp contrast to each other. The birth of one gives rise to another, thereby highlighting the interdependency of these two metrics for different entities at the same time.
Reiterating AR's definition, it is the amount of money that customers will soon pay you for utilizing your product/service. Therefore, AR constitutes an asset, not revenue.
When you record these values in a balance sheet, the dynamics take a slight twist.
According to the double-entry book-keeping system, if you sold $700 worth of your advertising services to Company ABC, this is how the value represents the balance sheet:
AR is the result of a sale, meaning your customers owe you money that adds value to your company's bank account. Thus, it is a debit to an asset account and credit to a revenue account.
Bad debts are standard in every business, no matter the size. For example, for every ten customers that you sell your product/service to, one ends up defaulting for various reasons.
When your client fails to make the payment, your business records a bad debt on the balance sheet. As your work grows and expands, you should predict the levels of approximate bad loans. Failure to do so will highlight unrealistic values of account receivable, misleading the actual financial health of your organization.
This prediction is noted under an Allowance for Uncollectible Account. This account spotlights a percentage of accounts receivable that will not convert into revenue. However, this estimate is subject to change with actual customer behavior.
For example, you forecast to make $150,000 from your agency this year. With research, you conclude not to receive 4% of the account receivable. Your bad debts for the year would be 150000*0.04 = $6,000, which records in your books as the following:
The value gets booked under bad debt expense. Continuing the above example, if your client ghosts you for the $6,000 owed, your accounting books will reflect the following modification:
$6,000 'debited' from Allowance for Uncollectible Accounts and 'credited' to Accounts Receivable. This is because the allowance is an estimate that gets erased on account of ghosting.
There are times when your bank accounts will receive unexpected credits, like the $6,000 once declared as a bad debt. A win for you, indeed! But, how do you amend these changes in your accounting books again?
Debit the $6,000 from accounts receivable to credit the value under the revenue tab.
While credit periods are a natural phenomenon in a running business, it's best to keep low values under your company's AR tab. This is because late payments are significant reasons to drive companies to struggle with cash problems.
However, accounts receivable hold importance in the business world. AR forms an essential element of financial analysis, highlighting the actual health of an organization that assists in making important decisions.
Supporting factors like liquidity levels come from AR levels, serving as positive signs to satisfy investor sentiments or as an alert for leaders to adopt contingency plans.
Offering a credit period fosters building a genuine relationship with your customers. However, things can quickly slip out of hand if not monitored closely. This is where Accounts Receivable Turnover Ratio comes into play.
This ratio evaluates a company's effectiveness of its credit extensions.
The formula for this turnover ratio is:
Accounts Receivable Turnover Ratio = Total Net Sales / Average Accounts Receivable
Where average accounts receivable sum the starting and ending accounts receivable over a specified period, divided by 2.
For example, your advertising agency records an accounts receivable of $3,000 in January 2021 and $1,750 in December 2021. The total net sales for the year were $85,000.
Calculate the Average Accounts Receivable = 3000 + 1750 / 2 = $2,375
Plug the values in the accounts receivable turnover ratio.
Turnover Ratio = 85000 / 2375 = 35
The 35 here implies that your agency's customers are diligent in paying their dues.
Note: Higher the turnover ratio, the better is your customer paying timeline.
As a creative business that offers extended credit periods, it becomes overwhelming to track delayed payments of multiple customers. If you find yourself on the path of this tricky activity, create an accounts receivable aging schedule.
The accounting table breaks down information in an easy-to-read and understandable format. It divides the customer's data and delayed invoice amounts under their respective timelines.
This clarity is helpful for organizations to assess their cash flows and evaluate operational performances. The table is valuable to understand a company's actual performance, acting as deal-breakers during loan raising pitches.
For example, your agency has multiple clients who make late payments. Let's create a tab of their activities in the aging schedule table:
Here, the numbers highlight that you need to start sending reminder emails and calls to Lora Dany and Jerry & Friends Co. to record revenues in your accounting books.
As a creative business owner in the US, we believe you should focus your energy quota on bringing out the best of your artistic self.
With late payment tracking, bad debts, and accounting book alterations demanding a big slice of your workforce and in-house resources - let Fincent's finest bookkeepers manage your books and bring you more peace of mind.
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