Accounts receivable represent sales made to customers who have not yet paid for them. Accounts receivable are thus monies owed to the firm from customers.
Accounts receivable is presented on the balance sheet under current assets. Under U.S. GAAP, accounts receivable must be presented at their net realizable value. This requires the company to create a reserve account, allowance for doubtful accounts, as an offset to accounts receivable. When the company identifies an uncollectable debt, it then charges the debt against this reserve account. This method of accounting for bad debts is called the allowance method.
Smaller firms not reporting under GAAP use the direct write-off method. Under the direct write-off method, a company expenses a bad debt when the bad debt is identified.
The accounts receivable account has important implications for cash flow. When the accounts receivable balance increases from the prior period, it means that sales exceeded cash collected from customers by an amount equal to the increase in receivables. If accounts receivable decrease from the prior period, then cash collected from customers over the period was greater than the period’s sales. In other words, an increase in accounts receivable is a use of cash, while a decrease in accounts receivable is a source of cash.
Accounts receivable is also an important factor in determining a company’s quality of earnings – i.e., the extent to which accounting profits translate into cash flow. If a company’s receivables are growing faster than sales, that could be a sign that the company’s customers are not timely paying their bills or that the company is selling to riskier companies.
