Is Accounts Receivable an Asset or Liability? Here’s the Detailed Answer
When running a business, it is important to understand your financial statement. Possibly the most common question that every entrepreneur may face at the initial stage is, “Is accounts receivable an asset or a liability?”
However, accounts receivable may initially seem a little confusing because it involve the money you haven’t received yet. But comprehending its nature is a must for your business’s financial stability.
Therefore, in this informative article, we will guide you through the meaning of accounts receivable, their nature, calculation, and troubleshooting of their commonly associated risks.
- What is Accounts Receivable (AR)?
- Is Accounts Receivable an Asset or Liability?
- Various Treatment of Accounts Receivable
- How to Calculate Accounts Receivable Ratio?
- Differences Between Accounts Receivable and Accounts Payable
- Common Risks Associated With Accounts Receivable
- Effective Strategies to Manage Accounts Receivable Effortlessly
- Conclusion
- Frequently Asked Questions
What is Accounts Receivable (AR)?
Accounts receivable (AR) is a term that relates to the total amount of money a customer owes to the company for the goods and services that have already been sold on credit.
In simple words, the term “receivable” presents the fact that the company has earned the money because goods or services have already been rendered but is simultaneously waiting for the client’s payment.
Furthermore, the AR is considered the agreement between the company and the client in the name of “I owe you (IOU).” According to this, the customer has to make the due payment within a certain period.
Is Accounts Receivable An Asset or Liability?
The business’s accountants classify AR as a current asset on a balance sheet because it represents the money that customers owe to the company, generating economic benefits shortly.
To fully understand why AR is considered an asset, examine the given table attentively, as it states an important difference between an asset and a liability.
| Assets | Liability |
|---|---|
| An asset is a resource that enhances the financial value of a company. | A liability is a resource that a person or a company has to repay to an owed party. |
| It helps to boost the long-term economic profits. | It has to be paid off over a while. |
| Ex– Cash, inventory, investments, and machinery. | Ex– Business loans, taxes payable, and unpaid bills. |
Therefore, accounts receivable are referred to as the rendering of goods and services on credit.
As long as the company expects to collect its payment within a year, it will be considered a current asset. However, if the AR remains unpaid for over 12 months, then it will be recorded as a long-term asset.
Furthermore, the higher AR figure signifies that the company is failing to collect the payments on time. In such cases, the authorities deal with this by compensating for the bad debts with an allowance.
Similarly, for smaller AR, a company might implement the direct write-off method and mention these accounts as a loss or expense.
Consequently, accounts receivable are an asset, as they are meant to provide financial rewards now or later. Also, if a company fails to recover the payment on time, then it might turn into bad debt.
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Various Treatment of Accounts Receivable
Even with familiarity with the classification of accounts receivable, people are confused about its treatment in different statements. Thus, here we have laid down some basic treatments of AR; have a look:
- Balance Sheet: The AR is posted on the assets side of the balance sheet, right under the current assets column.
- Journal Entry: When the business sells goods or renders services on credit, the amount of AR is debited, and sales are credited. Conversely, when the business receives the due payment, AR is credited and cash is debited.
- Subsidiary Ledger: In the company’s accounts system, a distinct column is maintained in the subsidiary ledger for each client. This contains the purchase date, amount, and invoice number.
Therefore, understanding and performing the proper treatment of AR can help you to prepare an accurate financial statement and enhance risk management.
How to Calculate Accounts Receivable Ratio?
Measuring the AR ratio on a monthly or quarterly basis is important for any organization to know how well they are managing its assets and revenue.
A good overall ratio means the firm has been more successful at collecting the due payments from its clients. Whereas, a low ratio indicates that the accounts receivable is current asset that are now being converted into long-term assets.
Moving further, let’s see the easiest way to calculate the AR ratio without any difficulties.
The formula to calculate accounts receivable is:
Accounts Receivable Ratio = Net Credit Sales / Average Accounts Receivable
To illustrate: Max Electronics sells technology equipment to Nahar Boys College. Now, if they want to calculate their average AR ratio, they first need to know what their net credit sales are, along with the average AR.
To find out net credit sales, they will need the total amount of sales and then have to subtract the total amount of sales returns from it. Let’s suppose Max Electronics had $200,000 in sales and experienced $20,000 in returns. So, their net credit sale will be
Net Credit Sales =
$200,0000 – $20,000 = $180,000
Now, to calculate the average AR, add all the transactions recorded in the journal and then divide the answer by the total number of entries. For instance, the same business AR entries look like $2000, $600, $900, $2500, and $3645. So, their average AR will be:
Average Accounts Receivable =
$2000 + $600 + $900 + $2500 + $3645 / 5 = $1929
Finally, calculate the AR ratio by applying the given formula:
Accounts Receivable Ratio = $180,000 / $1929 = 93.31
In essence, monitoring the AR ratio timely will empower the business to know whether its current assets are reaping benefits for them or turning into bad debt.
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Differences Between Accounts Receivable and Accounts Payable
Accounts Receivable and Accounts Payable (AP) are two different fundamental accounting terms that represent the company’s incoming and outgoing cash flow.
Look at the below table of accounts payable vs. accounts receivable to determine the key difference between the two of them.
| Accounts Receivable (AR) | Accounts Payable (AP) |
|---|---|
| AR relates to the money that is owed to the company by its customers for the goods or services delivered on credit. | AP relates to the money that is owed by the company to its vendors or suppliers for the goods or services purchased on credit. |
| It is revenue that gives rise to a company’s future economic value. | It is outgoing money that is required to be paid off in the given period. |
| Recorded under current assets on the balance sheet. | Recorded under current liability on the balance sheet. |
| Aim to collect money on time. | Aim to settle the debt promptly. |
Thus, understanding the difference between both the respective terms is essential for managing the financial activities of any organization effectively.
Common Risks Associated With Accounts Receivable
As we know, AR is intended to enhance a company’s economic value. However, they come with various risks, including bad debts, late payments, and others. Let’s examine them individually.
1. Bad Debts
Bad debts refer to the money owed by the debtor (customer) that is identified as uncollectible and written off as an expense. This happens when the entity suspects it’s nearly impossible to retrieve the payment due to the customer’s financial state or their refusal to make a transaction.
For instance, you sell something to your customer on credit. If they won’t be able to pay or are willing to not pay you, that amount will convert from current assets to fixed assets and is defined as bad debt.
2. Cash Flow Challenges
Generally, companies grant 12 months to their customers so that they can clear the outstanding payments for the goods or services that have been handed over to them on credit.
But when these transactions didn’t settle down on time, the company might have had to face certain problems with its cash flow statement targets. This situation can affect the financial state of a company and also become a challenge to its further development.
3. Other Risks
A company can face complications that may be resolved but take time, and till then, they have to face the hardship. For example:
- Invoice Discrepancy: A situation where a mismatch occurs between what you have billed and what the customer has received. These might be printing errors or caused by confusion and may lead to late payment or disputes.
- Client Dispute: Poor AR management or late payments can raise disputes between the company and the client. This can badly impact the existing business reputation and market value.
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Effective Strategies to Manage Accounts Receivable Effortlessly
The goal of effective AR management is to optimize the bills, enhance the payment method, and foster the collection process to eliminate the risk of bad debts. And for that, it calls for some strategic actions to be carried out.
Therefore, take a look at the pointers below to perform successful receivable management.
1. Set a Clear Credit Policy
Whenever you sell something on credit to your customers, maintain a transparent credit policy between both parties. Your customer should understand the essential details, such as the payment period, penalties for delays, and other relevant information.
2. Offer Multiple Payment Options:
Provide various payment methods for your customers, such as bank transfers, checks, and online payments through UPI, to reduce the possibility of late payments.
3. Create Invoices Accurately
The invoice should be easy to understand and contain all the vital information, such as the billing date, amount, product/service details, and credit terms and conditions.
4. Verify Credit History
Before selling the goods/services to a new customer, check their credit history to reduce the bad debt risk.
5. Send Regular Reminders
Automated SMS/emails or follow-up calls before the due date will empower you to keep the average AR ratio low and boost the company’s financial status.
Therefore, adhering to the stated strategies will help you to maintain good cash flow, minimize fixed assets, and strengthen customer relationships. Ultimately, it will positively impact the overall business growth and financial stability in the long term.
Conclusion
To sum up, now that you know the correct classification of accounts receivable and understand whether Is Accounts Receivable An Asset or a liability, you can deal with your financial statements with more certainty.
Similarly, understanding the placement of AR on your balance sheet helps you to make clear and smart decisions for your business.
Lastly, stay tuned to keep learning and build a strong understanding of your financial statements because every small insight may contribute to long-term success.
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Frequently Asked Questions
Ans: AR is an asset, as it represents the money your customer owes to you for the goods and services that have already been delivered on credit.
Ans: Yes, AR is recorded under current assets if the payment is collected within a year. If the customer fails to repay or takes longer than 12 months to pay, it converts into a long-term asset.
Ans: No, AR is not considered a liability because it indicates the money your customer owes to you and eventually generates financial rewards in the future.
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