Accounts receivable (A/R) are outstanding balances that are yet to be paid by customers because of selling goods and services on account. A/R is an asset in the balance sheet and has a normal debit balance. Debiting A/R increases its balance while crediting it decreases its balance. Knowing what are accounts receivable can help small businesses manage cash flow, working capital expectations, and boost sales.
Key takeaways
- When recording A/R with a journal entry, we debit A/R and credit revenue.
- A/R has two sources: credit sales and dishonored promissory notes.
- Recording early payment discounts varies between the net and gross method.
- If you still wish to recover even a portion of the uncollected A/R, you may enter into A/R financing or factoring agreements. However, with financing, you’ll have to pay interest, whereas with factoring, you won’t receive 100% of A/R.
Accounts Receivable Journal Entries
Below are the entries for recording sales on account and customer A/R payments in the books.
With the popularity of accounting software like QuickBooks Online, there’s no need for these entries. You simply enter an invoice and the system will make the entry for you automatically. Read our guide on how to create and send invoices in QuickBooks Online to learn how the platform simplifies this process.
Sources of A/R
With accrual accounting, businesses must recognize revenue even if cash hasn’t been received from customers. The revenue is recognized by creating an A/R that is then offset when the cash is eventually collected.
1. Credit Sales
The vast majority of A/R come from allowing customers to purchase goods and services on credit. You issue them an invoice and expect them to pay at a later date.
Although it’s encouraging to give credit to customers to boost sales, A/R exposes you to the risk of bad debt. Hence, exercise caution in granting credit and grant credit only to customers with a good track record in paying.
2. Dishonored Promissory Notes
A more unusual source of A/R are when notes payable become overdue. A promissory note is a written promise to pay the creditor in the future. It may contain the words, “I promise to pay or order the sum of $X payable on mm/dd/yyyy.”
Since it is a promise to pay in the future, the maker of the note should pay on that date. In accounting, we record promissory notes in the notes receivable account, not as A/R.
Debtors who are unable to pay on the promised date dishonors the note and the amount becomes due on demand. When this happens, we should transfer the amount due plus interest from the Notes Receivable account to the A/R account because the amount needs to be collected right away.
Special A/R Considerations
There are additional considerations in A/R accounting. As a small business, you may encounter two or three of these special considerations, so it’s good to have knowledge on all of them.
1. Accounting for Early Payment Discounts
The invoice that creates the A/R should also state the payment terms, which includes the discount term and credit term. The credit term sets the number of days until the invoice is due, such as net 15 days or net 30 days.
If you want to speed up collections, give early payment discounts and include a discount term like 5/10, which means “5% discount if paid within 10 days.”
There are two methods for recording early payment discounts:
- The gross method records discounts only when the customer takes it, so we don’t record any discount in our initial journal entry. This method is straightforward and requires little effort.
- The net method records the discount right away. But if the customer doesn’t pay within the discount period, an adjustment must be made which adds more steps for the bookkeeper.
The best method to pick depends on your customer’s payment patterns. If most of them take the discount, then use the net method. Otherwise, stick to the gross method.
For illustration, let’s assume that we sold goods for $2,000 before 6% sales taxes. We gave them a payment term of 5/10, net 30 days. Click the example to show the journal entries for each method.
To record sales on account
Debit | Credit | |
|---|---|---|
A/R | 2,120 | |
Sales | 2,000 | |
Sales Tax Payable | 120 |
To record receipt of payment assuming the customer didn’t take the discount
Debit | Credit | |
|---|---|---|
Cash | 2,120 | |
A/R | 2,120 |
Under the gross method, we record sales at its gross amount and later on record sales discounts when customers take the discount. If customers don’t take the discount, we simply record the total amount due.
To record receipt of payment assuming the customer took the discount
Debit | Credit | |
|---|---|---|
Cash | 2,014 | |
Sales Discounts (2,000 × 5%) | 100 | |
Sales Tax Payable [$120- ($1,900 x 6%)] | 6 | |
A/R | 2,120 |
If the customer takes the 5% discount, net sales should be $1,900, which is computed as $2,000 minus $100 discount ($2,000 × 5%). But since we initially recorded sales at gross amount, we need to record the discount to the Sales Discounts account–a contra-revenue account–to reduce gross sales to net sales.
The applicable sales tax should be $114 ($1,900 × 6%), not $120 as seen in the initial entry. We need to adjust the sales tax payable account by debiting it $6 to reduce it to $120. The amount paid by the customer is now $2,014 after deducting sales tax and discount.
To record sales on account
Debit | Credit | |
|---|---|---|
A/R | 2,020 | |
Sales (2,000 × 95%) | 1,900 | |
Sales Tax Payable | 20 |
Under the net method, we immediately considered the effect of the discount as if the customer would take it. In financial reporting, the net method is preferred since it reports A/R at its net realizable value, which is the amount the company can expect to collect.
To record receipt of payment assuming the customer took the discount
Debit | Credit | |
|---|---|---|
Cash | 2,020 | |
A/R | 2,020 |
Since the discount is already applied in the initial entry, we debit cash and credit A/R.
To record receipt of payment assuming the customer didn’t take the discount
Debit | Credit | |
|---|---|---|
Cash | 2,120 | |
A/R | 2,020 | |
Sales Discounts Lost | 100 |
If the customer didn’t take the discount, here’s where a bit of complication arises. You have to add an account called sales discounts lost to record the amount of discount forfeited. In daily bookkeeping, the net method adds an extra step while the gross method is pretty straightforward.
To encourage customers to pay within the discount period, send them emails or reminders. If ever they’re not interested in the discount, you should instead remind them if the due date is near.
You can see all outstanding A/R easily in an A/R aging report. We recommend that you check this report every month to monitor and stay on top of outstanding A/R.
2. Write-offs for Uncollectible Accounts
When customers fail to pay on the due date, you have to call them constantly to settle their remaining balances. Sending them collection letters is another way to formalize collection requests because there’s a document showing your intention to collect.
However, there’s still a possibility that some customers will not pay. In cases like this, you have the option to write off the account and shoulder the loss. Writing off A/R is the last resort, especially if there is a remote chance of collectibility.
To illustrate write-offs, let’s assume that one of the customers hasn’t paid their dues that have been outstanding for almost a year. The total unpaid amount is $400. The journal entry to write off uncollectible accounts under the direct write-off method is:
Debit | Credit | |
|---|---|---|
Bad Debts Expense | 400 | |
A/R | 400 |
The direct write-off method negatively impacts net income because we debited bad debts expense. If several accounts are written off, net income would show unnecessary fluctuations, which would not be good. To avoid direct write-offs, businesses use the allowance method.
Under the allowance method, the write-off journal entry should look like this:
Debit | Credit | |
|---|---|---|
Allowance for Bad Debts | 400 | |
A/R | 400 |
The allowance for bad debts account is a balance sheet account that carries all bad debt estimations. Whenever we decide to write off an account, we just debit the allowance account instead of bad debts expense.
3. Recovery of Accounts Written Off
In very rare instances, some customers may resurface and pay their outstanding balances. If you have already written off their accounts, you have to use an account called bad debts recovered to record the bad debt recovery in the income statement.
Let’s say our customer with an outstanding balance of $200 paid after one year. We had already written their account. Therefore, to record the recovery, we should perform the following entry:
Debit | Credit | |
|---|---|---|
Cash | 200 | |
Bad Debts Recovered | 200 |
4. A/R Financing & Factoring
If you don’t want to write off accounts and still wish to recover even just a portion of the unpaid A/R, you can go for A/R financing or factoring. Both alternatives enable you to bridge short-term cash flow gaps due to uncollected receivables from customers:
- A/R financing involves borrowing against your uncollected invoices from customers wherein the lender charges interest for each week that the invoice has been outstanding. The lender collects the invoices from customers and uses them to repay the loan:
- While A/R Financing is much cheaper than A/R Factoring, you’re still on the hook for any bad debts. You’ll need to repay the loan from the lender even if you’re unable to collect from the customer.
- A/R factoring, also called invoice factoring, involves the sale of outstanding receivables to a factoring company in exchange for receiving a portion of the outstanding A/R. Usually, factors only pay 80% of the factored A/R plus other fees applicable:
- With A/R Factoring, you’ve sold your A/R, and the risk of bad debt falls on the factoring company.
You can resort to financing or factoring if your business is short on cash for working capital requirements.
Frequently Asked Questions (FAQs)
Debit accounts receivable for the total invoice amount, credit sales by the invoice subtotal, and credit sales tax payable for the amount of sales tax charged.
It is an asset. Particularly, it is a current asset in the balance sheet because it is expected to be collected within the next 12 months.
Bottom Line
Knowing what are accounts receivable is key to understanding customer behavior and payment patterns. Beyond its accounting processes, you can use your knowledge of A/R to plan cash flow and estimate the needed working capital for operations.
