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An important part of building a business relationship is extending credit. It encourages repeat sales, boosts revenue, and speeds up the supply chain. The term “account receivable” is when a business allows a customer to take immediate possession of a product/service, in return for a promise to pay.
Accounts receivable (abbreviated as AR or A/R) refers to any of the following:
- Unpaid or outstanding invoices
- Late payments
- Sales issued on credit
- Money expected from customers
It represents payments for goods and services rendered on specific credit terms. AR implies anticipated payments are enforceable and legally binding. In an accounting system, accounts receivable is recorded on the balance sheet as an asset.
How to Process Accounts Receivable
A plan should always be in place for how a company wants to handle accounts receivable. The AR process refers to the collection, management, and monitoring of all outstanding invoices. It delivers cash to a business, strengthens consumer relationships, streamlines the supply chain, and leverages growth.
Credit procedures can be established for how credit is processed, who receives it, and what happens next. The most effective AR process includes credit management, invoicing, documentation, and consistent monitoring.
The Step-By-Step Accounts Receivable Process
- Develop a Credit Application Process
- Create a Collection Plan
- Compliance with Consumer Credit Laws
- Send Out Invoices
- Choose an Accounts Receivable Management System
- Track the Collection Process
- Log All Charges and Expenses in Real-time
- Incentivize Early Payment Discounts
- Build and Maintain Customer Relationships
- Create a Plan for Escalation
Accounts Receivable Cycle
The accounts receivable cycle starts when a service/product has been delivered, and is completed when the invoice is settled, and the amount paid in full.
The following are the key steps to follow in the accounts receivable cycle:
#1) Create a credit application process
#2) Send invoices to customers
#3) Establish payment terms and due dates
#4) Monitoring and reporting
#5) Recording AR activity
The purpose of following an AR cycle is to keep positive cash flow consistent. It helps to avoid bad debt by collecting on invoices before they are past due.
Managing the lifecycle involves encouraging clients to pay, sending invoices and reminders, updating the trial balance sheet, and monitoring progress.
Accounts Receivable Turnover
The accounts receivable turnover ratio (also called the “receivable turnover” or “debtors turnover” ratio) is a metric that measures how effective a business is at extending credit and collecting debt. It’s calculated by dividing net credit sales with the average accounts receivable.
Net Annual Credit Sales ÷ Average Accounts Receivables = AR Turnover
The higher the ratio, the better the business is at managing customer credit. Its an efficiency measurement used in financial statement analysis.
The ratio also quantifies how well a company manages credit, and how long it takes to collect the outstanding debt. The ratio is factoring how many times a company collects accounts receivable (on average) throughout the year. Hint: it should be every month.
AR Ratio Formulas
Net Sales
Gross Sales – Refunds/Returns – Sales on Credit = Net Sales
Average Accounts Receivables
(Beginning Accounts Receivable + Ending Accounts Receivable) ÷ 2 = Average AR
Accounts Receivables Turnover
Net Annual Credit Sales ÷ Average Accounts Receivables = AR Turnover
Accounts Receivable Turnover in Days
Accounts Receivables Turnover Ratio ÷ 365 = AR Turnover (in days)
Examples of Accounts Receivables
Posting accounts receivable is a routine task that must be completed each month. AR is considered a “current asset” and includes both cash and cash equivalents. The asset account has:
- Cash
- Accounts receivable
- Inventory
- Prepaid expenses
- Short-term loans
- Investments
An example of accounts receivable is a utility bill. An electric company provides electricity and then bills customers at the end of the month. The service has already been provided and credit extended.
After the electric company bills out for the service provided, it records the debt as an account receivable. Once payment is received, it is documented on the balance sheet, and the general ledger should balance.
How to Record Accounts Receivable on a Balance Sheet
Although most companies now use automated software for entering account balances, it’s good to know the manual journal entry method for accrual accounting.
In this system, the accounting department records a transaction whether or not payment has been received. It adds a credit to the sales account and a debit to the AR account. Once a business receives payment, the “cash” account receives a debit, and the AR account is credited.
The exact system for managing accounts receivable on paper depends on the accounting method used. AR team members should be educated on all procedures and how a given method can affect the entire AR cycle.
Accounts receivable can be found under the “current assets” section on your balance sheet or chart of accounts.
Benefits of Accounts Receivables
The more trust and credit extended—that’s honored with on-time payments, the more successful a business will be. There is mutual interest in maintaining an organized AR department for all parties involved. Benefits include:
Speed and Efficiency
The average manual process for an invoice takes 50 to 72 days. Quicker invoicing leads to faster payment collection, with shorter days sales outstanding (DSO).
Invoice processing through automated solutions like Tipalti streamlines the entire process. The following can happen in just minutes:
- Invoice submission
- Processing
- Invoice is translated, enriched, and validated
- Documents delivered to buyers
- Archived to meet regulatory requirements
A typical AR employee can process between 7,500 and 30,000 paper invoices per year, compared to more than 125,000 electronic invoices. This is 17x greater efficiency than the traditional method.
Consistency and Accuracy
Automation means fewer manual errors and guaranteed invoice delivery. There is no more “getting lost in the mail.” When the AR cycle is automated, there is end-to-end process visibility for the entire accounting team.
Automating the AR cycle leads to a higher rate of accuracy and consistency. It gives a business a more standardized process for cash flow with accurate data analysis and real-time reporting.
Cash Management
In a traditional, paper-based AR approach, employees spend a large amount of time laboring over each invoice, responding to customers, handling exceptions, recording data, etc.
Automation cuts through all of that. Tasks are performed quicker, with fewer errors, and a greater level of efficiency.
Proper AR management helps a business free up working capital. The accounting team can focus on more value-add tasks and growth. It helps to reduce expenditures on labor, printing, supplies, and mailing overhead. It can save 60%-80% on every invoice and generate a greater amount of liquidity.
Forecasting
Ad hoc reports, real-time dashboards, and other automated tools provide transparency across the entire AR cycle, allowing instant access to critical data. This includes information needed for predictive analytics, like:
- Amount owed
- Payment due dates
- Delivery status
- Performance over time
The right automated AR platform will deliver key insights and uncover opportunities to improve forecasting.
Security and Compliance
Paper accounts receivable cycles are much more susceptible to hackers, phishing attacks, data breaches, fraudulent invoicing, and GDPR non-compliance. An automated AR solution sends 100% of your invoices electronically through a single provider, regardless of the delivery method or customer’s industry, size, or location.
Modern compliance can be complicated—especially with global commerce. Location-specific regulatory mandates change depending on your customer.
E-invoicing enables real-time, electronic submission to the proper authorities, ensuring tax compliance, legal security, and cost reductions. This extends to archiving all documents as well.
Additional Benefits:
- Improve customer loyalty and retention
- Less exception handling
- Track uncollected profits
- Develop workflow automation strategies
- Streamlined customer experience
- Higher staff retention rates
- Overall fiscal organization
Accounts Receivables FAQs
What Happens if Accounts Receivables Aren’t Paid?
When an account receivable goes unpaid, it will be written off as bad debt. Also called “account uncollectible” it represents any receivables, loans, or debts that have virtually no chance of being paid.
There are many reasons why this can occur, including bankruptcy, fraud, and lack of proper documentation to prove the debt.
For bookkeeping purposes, the amount will be written off with journal entries as a debit to allowance for doubtful accounts, and as a credit to accounts receivable. When it is confirmed that no payment will be received, it will be reflected in the income statement with the amount not collected as a bad debt expense. Increasing a bad debt expense will reduce profit.
Where Does a Company Track Accounts Receivables?
A company that doesn’t monitor AR and enforce a collection policy may not generate enough cash flow to operate. Borrowing from a line of credit incurs interest costs. That’s why it’s important to consistently monitor and track AR metrics to ensure things are running smoothly.
The best way to track accounts receivable is with an aging schedule. This report groups AR balances based on the due date; 0-30 days, 30 to 60 days, etc. The goal is to minimize the amount of money in the oldest buckets.
A number of strategies can help to increase cash collections and reduce the receivable balance. The aging schedule also depends on the industry. Companies that are typically paid over a period of months will have a larger dollar amount of receivables in the 60+ day category. This is another report that can be compared to industry averages.
How are Accounts Receivables Different from Accounts Payables?
An overview of a company’s balance sheet will show that while accounts receivable is an asset, accounts payable is a current liability. The AP balance is the total amount of unpaid bills a business owes to third parties. Accounts payable can take the form of operational costs, recurring bills, and general expenses.
Accounts payable vs. accounts receivable will show that although the accounting practices are different in purpose, there are similar practices for handling both accounting workflows.
For a small business, business owners usually assign one person to handle both systems. In a larger operation, it’s helpful to separate the two functions and assign a specific individual or team to each one.
Current assets minus current liabilities equals working capital. In order to remain financially sound, a business must generate enough assets to pay for the liabilities.
A Smart Way to Track Accounts Receivables
When invoicing volume and complexity are eating up too much time, automation is the answer. It’s the best way to track the accounts receivable process. When a business needs to free up resources for more valuable work, the right solution needs careful evaluation.
Although many accounting automation platforms require an extensive setup and configuration, Tipalti is quick and simple to implement. It’s a smart way to track accounts receivables and reconcile accounts.
The general ledger account reconciliation process for balance sheet accounts helps accountants and bookkeepers ensure that transactions are properly recorded at month-end for financial statements and effective internal control is in place.
Benefits of AR automation
- Streamline collection workflows
- Digitize invoice creation
- Accurate data analysis
- A standardized process for consistency in cash flow
- Save time and costs spent on manual collection process
Traditional vs. Modern Accounts Receivable
The traditional approach to accounts receivable is to manually generate invoices from spreadsheets in batches, sometimes daily. These invoices would be printed and mailed or emailed to begin the AR process.
The traditional method involves a lot of manual entry, extra time, and labor costs. Everything is logged by hand on the balance sheet, opening the possibility up to human error.
The manual AR process usually involves:
- Generating invoices through Excel or MS Word
- Printing invoices, then mailing or emailing them out
- Manual payment verification and follow-up through calls/emails
- Manual journal entry and bank reconciliation
It’s time-consuming with a huge potential for error.
The modern accounts receivable approach uses automated software. It takes the output from ERP systems to automate the delivery of invoices. These can be sent by post, email, or a range of digital options like XML or EDI.
Electronic invoices give real-time visibility of the payment status to a business. This is done by embedding links to payment methods in the invoice, including direct debit, credit card, and other online payment options.
With AR automation, everything is instantly updated and data gathered in reports so staff can spend more time identifying patterns, and less time chasing paper.
The Most Common Accounts Receivable Pain Points
Poor Cash Management
Overdue invoices mean sluggish collections. Mismanagement of accounts receivable leads to poor cash flow and longer payment cycles. Failing to understand AR across different regions, bank accounts, and entities can lead to poor cash management.
Overdue Invoices
Any time a customer is behind on payments, it puts a dent in a company’s revenue performance. Make sure there’s a clear plan to follow up on a regular basis.
The longer invoices are left to languish, the less cash a business has to play with. The lack of clear policies that detail late payment consequences (like late fees) can also lead to lackadaisical payments from customers.
Manual Processes
If there’s someone stapling invoices and stuffing envelopes in your AR department, they’re doing it wrong. Manual processes are a waste of time and there are too many opportunities for human error. A business will find it difficult to remain in a competitive space without considering automation to keep up.
Inaccurate Reporting
If accounting software or systems are not updated, it could result in inaccurate reporting. Make sure staff is entering all required data in the system to properly match and process invoice payments.
If invoices have been paid but not noted in the system, the trial balance will be off. Staff may call on invoices that have already been paid and put a strain on customer relationships.
Tips for Improving Accounts Receivable
If you’re wondering how to improve the accounts receivable process, here are a few places to start:
Formal Written Policy
Create a formal policy and stick to it. For example, if an invoice is later than 30 days, send an email. At 60 days, make a phone call. Enforcing the policy ensures a higher quality of customers and faster payments. You may even choose to charge late fees after a specific due date.
Provide an Estimate/Quote
Before signing a business agreement, a company should provide the customer with an estimate. The quote includes the specific products/services sold, sales price, credit terms, etc.
This process enables customers to have an advanced understanding of costs and to avoid any surprises. This leads to a quicker invoice approval process and faster payment.
Managing Bad Debt
Accounts receivable balances that cannot be collected should be reclassified as a bad debt expense. The easiest way to handle bad debt is to write it off. The receivable balance is then converted to a bad debt expense.
Establish Key Performance Indicators
Key performance indicators (KPIs) measure the health of the accounts receivable cycle. One of the most important metrics to watch is called days sales outstanding (DSO). This tracks the average amount of time it takes to get paid after invoicing. Other metrics to monitor are:
- Invoice accuracy
- Average days to invoices
- Credit overruns
- Customer complaints
Baseline data should be used to set benchmarks. Then, goals can be set for each measurement to optimize AR collection management.
Regular Aging Review
Proactively manage the collection process immediately upon invoicing. The aging report must be viewed frequently, and the appropriate actions taken. Accountability should be given to an AR staff member and a plan established for following up with delinquent accounts.
Different Payment Methods
Providing customers with several different ways to pay, enables faster payment. In addition to paper checks, accepting credit cards and ACH payments can shorten the entire AR cycle and increase cash flow. In today’s world, payments can even be made on a mobile device in a matter of minutes.
Create a Follow-up Policy
Create a follow-up policy that universally applies to all clients. Any time a payment is missed, a team member should send out a notification. AR software will instantly do this when an invoice falls into a certain bracket of “past due”. It will automatically send digital reminders for delinquent accounts.
Negotiating Late Payment
If a customer is honest and cannot pay on time, offer a discount of 1-2% if they pay in ten days. A business might lose some revenue with the new payment terms but it’s a final way to incentivize customers before hiring a collection agency.
Input Payments Immediately
All payments should be input immediately. The funds must be applied in the accounting records to a specific invoice and closed out. This ensures all management has the most up-to-date aging report for review and nothing is misapplied or collected, when it has already been paid.
Dispute Process
Invoice disputes can hurt a business relationship if not handled properly. By establishing a policy for disputes, a company gets ahead of these issues. This includes answering questions like:
- Who handles client contact?
- What type of supporting documents are needed?
- What is the procedure for failed payment?
The faster issues are resolved, the more a business relationship can continue.
Forecasting
Forecasting allows a company to compare invoices for recurring charges against expectations to determine if there was any failure in the system. Automating the process means invoices are sent on the same day, every month, to avoid any unexpected delays.
Companies with customers that are charged on a monthly, quarterly, or annual basis should have accounting procedures to schedule future invoicing.
Use Automation
The best thing a company can do today is to automate as much of the accounts receivable process as possible. Leverage AR software for help with tasks like:
- Eliminate time spent on manual tasks
- Generate automatic reminders and
- Reports over a period of time to stay on track
- Analyze financial metrics and KPIs
Automation reduces the risk of errors, and recurring invoices are processed in far less time.
Sending electronic invoices (and providing an online payment option) encourages customers to pay quickly. This, in turn, speeds up the cash collections. Best of all, invoice automation improves the overall customer experience and leads to higher revenue.
In Closing
Keeping track of accounts receivable can be a complicated process. The tighter controls a company has on the invoicing and the collection process, the less bad debt it will incur.
It’s always a balancing act to collect on-time payments while maintaining a positive customer relationship, and a healthy flow of cash. That’s where automation comes in. When a robot handles mundane tasks, real people have more time to innovate, create, and help a business grow.
