Accounts Receivable

Accounts receivable is the total a business's customers owe it for goods or services already supplied on credit. It appears among current assets on the balance sheet, because the business expects to convert it to cash within a year, and it is created at the moment a sale is recorded rather than at the moment payment arrives. SEC Regulation S-X, which sets the format for filed balance sheets, lists it as line item 3, "Accounts and notes receivable," and requires amounts receivable to be stated separately by who owes them: customers, meaning trade receivables; related parties; underwriters, promoters and employees where the amount arose outside the ordinary course of business; and others. That separation exists because the four classes are not equally likely to be paid.

The working tool is the aging schedule, which sorts the outstanding invoices by how long they have been unpaid, conventionally into current, 1 to 30 days past due, 31 to 60, 61 to 90, and over 90. Two businesses with the same receivables total can be in entirely different positions: one where almost everything is current and one where a third of the balance is past 90 days. The aging is what distinguishes them, and it is also the basis on which a business estimates how much of the balance it will never collect, since the probability of collection falls sharply as an invoice ages. That estimate becomes an allowance for doubtful accounts, carried as a reduction of the receivables figure so the balance sheet shows what the business realistically expects rather than what it is owed on paper.

Speed is measured two ways, and they are the same fact expressed differently. Receivables turnover divides credit sales for a period by the average receivables balance over that period, giving the number of times the balance was collected and replaced. Days sales outstanding converts that into days, by dividing the average balance by credit sales and multiplying by the number of days in the period; a business with $80,000 of average receivables against $960,000 of annual credit sales has $80,000 ÷ $960,000 × 365, or about 30 days outstanding. Neither number means anything in isolation. A 45-day figure is comfortable in a trade that invoices on net-60 terms and alarming in one that invoices on net-15, and the SEC's own guide notes that desirable ratios vary by industry. What the numbers are good for is comparison against the same business's own history and against its stated payment terms: a business invoicing on net-30 with 58 days outstanding is not being paid on the terms it set.

Receivables are where growth quietly consumes cash. Every additional sale made on credit adds to the balance before it adds to the bank account, so a business growing its sales by half will typically be carrying half again as much in receivables at any moment, funded out of its own pocket. That is the mechanism behind the familiar and otherwise puzzling situation of a profitable business short of money, and it is why the receivables line is usually the largest single adjustment in the operating section of a cash flow statement. It is also why credit terms are a financing decision and not just a sales one: extending net-60 rather than net-30 to win an account means lending that customer the invoice amount for an extra month, at the business's own cost of funds.

The tax treatment of an uncollectible invoice follows the accounting method, and the direction surprises people. A business on the accrual method recorded the sale as income when it invoiced, so when the debt goes bad it deducts the amount it already took into income. A business on the cash method never recorded anything, and so has nothing to deduct. The regulation states the condition plainly: worthless debts arising from unpaid wages, salaries, fees, rents "and similar items of taxable income" are not allowed as a bad-debt deduction "unless the income such items represent has been included in the return of income" for that year or an earlier one. The loss to a cash-method business is real, but it is a loss of income that was never taxed rather than a deductible expense. The same regulation adds the symmetrical rule for a surprise payment later: an amount recovered on a debt that was deducted in a prior year goes back into gross income in the year of recovery.

1. The business delivers goods or services and invoices the customer. On the accrual method the sale is recorded as revenue now, and an equal amount is added to accounts receivable.

2. The receivable sits on the balance sheet as a current asset until the customer pays, and it counts toward working capital while it does.

3. The balance is aged. Invoices are grouped by how long they have been outstanding, which shows both collection performance and where the risk is.

4. Collection converts it to cash. The receivable falls and cash rises, with no effect on reported profit, because the profit was recorded at invoicing.

5. What cannot be collected is written off, reducing the receivables balance, with a deduction available only to a business that had included the amount in income in the first place.

Consider an example. A commercial cleaning company invoices on net-30 and ends the year with $310,000 of accounts receivable against $1,860,000 of credit sales. Days sales outstanding is $310,000 ÷ $1,860,000 × 365 = 61 days, so the business is waiting roughly twice as long as its own terms allow. The aging shows $140,000 current, $50,000 at 1 to 30 days past due, $30,000 at 31 to 60, and $90,000 over 90 days, of which $62,000 is owed by a single customer that has stopped returning calls. If that $62,000 is written off, receivables fall to $248,000, and because the company reports on the accrual method it had already taken the $62,000 into income and can deduct it. Had it been on the cash method, it would never have recorded the $62,000 as income and would have no deduction to take, which does not make it better off: the same $62,000 of work went unpaid either way.

Pros

• Offering credit terms wins business. Many commercial customers will not buy on any other basis, so receivables are the price of selling to them.
• The balance is an asset that can be borrowed against or sold, which gives a business a financing option it would not otherwise have.
• An aging schedule is an early warning system. A drifting balance shows a customer in trouble well before a default does.
• Collected receivables convert straight to cash with no effect on reported profit, because the profit was recognized when the invoice was raised.

Cons

• It ties up cash. Every unpaid invoice is money the business has spent and not recovered, funded from its own working capital.
• It grows with sales, so the faster a business grows the more of its cash is locked in receivables at any moment.
• Some of it will not be collected, and a concentrated balance turns one customer's failure into the business's own.
• A business on the cash method that never collects an invoice gets no deduction for it, because the income was never included in the first place.
• Chasing payment takes time and damages relationships with the customers it is aimed at.