Accounts Receivables on the Balance Sheet
Accounts Receivable Analysis
Accounts receivables, which are sometimes shortened to just "receivables", represent money that is owed to a company by its customers for products or services that it has delivered but for which it has not yet received payment. The nature of a company's accounts receivable balance depends greatly on the sector and industry in which it operates, as well as the particular credit policies management has set in place.
How Accounts Receivable Are Recorded on the Balance Sheet
The best way to help you understand account receivables is to walk you through what a typical transaction might look like so you can see how it ends up on the balance sheet. For the sake of clarity, I'm going to oversimplify the process a bit — in modern corporate America things are dealt with electronically and with more controls but the basic principles are the same — so you get a solid overview of how the pieces fit together.
Imagine that Wal-Mart wants to order a new special edition boxed set of Harry Potter from the publisher, to be released exclusively in its stores. It negotiates a 50,000 unit run that won't be available anywhere else; custom artwork, unique bindings, autographs, limited-edition bookmarks, the works. The books are printed and the final packaging assembled and the publisher will charge Wal-Mart $30 per set.
Wal-Mart will sell the sets for $90 each to its customers.
When the publisher ships the 50,000 units to Wal-Mart, it is going to include a bill for $1,500,000. That is the money owed to the publisher (50,000 x $30 = $1,500,000). Wal-Mart physically has the books but the publisher hasn't been paid even though it is legally entitled to its money.
Accounts Receivable Terms
Generally, a company that sells a product on credit sets a term for its accounts receivable. The term is the number of days customers must pay their bill before they are charged a late fee or, alternatively, the accounts receivable balance is either turned over to a collection agency or the firm sues the person or institution that owes it money, seeking relief from a court by seizing assets.
There are a number of customary accounts receivable terms. Normally, these will be expressed as "Net 10", "Net 15", "Net 30", "Net 60", or "Net 90"; the numbers refer to the number of days in which the entire net amount is expected to be paid (e.g., Net 10 means you have ten days from the time of the invoice to pay your balance). To free up cash flow and increase the speed at which it can access funds, many companies will offer an early-pay discount on longer-dated accounts receivable balances in the hopes of having their customers pay them sooner. Usually, it is in the customer's best interest to do so because the discount works out to a compound annual growth rate far in excess of what it could earn elsewhere.
While having lots of accounts receivable on the balance sheet is good — who doesn't want a torrent of future, expected cash coming their way? — it can bring serious problems to a business if not managed prudently. What if Wal-Mart went bankrupt or simply didn't pay the publisher? The publisher would be forced to write down the accounts receivable balance on its balance sheet by $1.5 million. This could be devastating. Look closely at a firm's accounts receivable book. Is it well diversified? Too much concentration — one customer or client representing more than five or ten percent of the accounts payable — might be cause for concern.
Normally, companies build up something called a reserve to prepare for situations such as this. Reserves are specific accounting charges that reduce profits each year, meant to approximate anticipated losses.
(Brush up on your knowledge about Capital Surplus and Reserves on the the Balance Sheet.) If reserves are inadequate or need to be increased, additional charges need to be made to the income statement. Reserves are used for all sorts of accounting entries, ranging from warranty return expectations to bad loan provisions at banks.
Some Businesses Don't Require Accounts Receivable
There are some businesses that actually get paid upfront. In this case, the business doesn't record an accounts receivable but, rather, enters a liability known as unearned revenue or prepaid revenue. As the money is earned, either by shipping products, making progress throughout the manufacturing process (when using the "percentage of completion" method), or the passage of time, it gets transferred from unearned revenue to revenue, reducing the liability and increasing reported sales.
A good illustration of this is the asset management industry. Clients often have the fees paid to a Registered Investment Advisor billed quarterly, in advance. The advisory company receives the cash but hasn't, actually, earned that cash in whole or part unless there is a provision requiring, say, written notice thirty days in advance, in which case it'd have immediately earned the first 1/3rd of the quarterly prepaid revenue. Each business day that passes, a certain percentage of fees become earned and non-refundable. An asset management company that opted to bill in arrears, on the other hand, would temporarily have an accounts receivable balance on its balance sheet, usually for only a day or two as fees are deducted from client custody accounts in most cases.