Is accounts receivable an asset or a liability?

However, that’s only the simple answer to the question. While in usual circumstances accounts receivable is an asset, there are situations in which it can become a liability. Learning more about what AR is – and why it’s usually considered an asset – can help you prevent it from becoming a liability while also highlighting the value of an optimized AR process.

Why accounts receivable is considered an asset

So why is accounts receivable an asset? Let’s start by exploring the terms in more detail:

• What are accounts receivable? Accounts receivable is the money owed by customers with a legal obligation to pay for the goods and services they have purchased. They are expected to do so in accordance with the agreed payment terms – typically outlining a payment window of 30, 60, or 90 days.
• What is an asset? An asset is a resource owned by a business with economic value, expected to generate revenue or benefit in the future. Reported on the balance sheet, a current asset is one whose value is used up or converted to cash within a year (or the normal operating cycle, if longer).

Since AR represents money owed and not held, it is treated as an asset. It remains an asset – a resource that has the means to generate revenue – until the business receives the cash for the goods and services supplied. At that point, the asset’s value is realized and it becomes working capital that can be put to use.

Any asset’s degree of liquidity is the speed and ease with which it can be converted into cash. Cash itself is the ultimate liquid asset. While recorded as a current asset, AR is illiquid until the monies due are actually received and become revenue.

When are accounts receivable a liability?

Returning to the question, ‘is accounts receivable a liability or asset?’, it’s important to note that AR can sometimes become a liability.

When businesses extend credit to their customers, the invoice they issue creates an accounts receivable balance. The assumption is that accounts receivable can be considered an asset because the customer is legally obliged to settle their debt within the outlined payment window. But in reality, customers do not always pay their invoices on time, or at all.

There are several reasons AR might not be collected in a reasonable timeframe, such as a dispute over the quality or quantity of goods supplied. Complete non-payment of accounts receivable usually results from more serious problems, like the customer business experiencing significant cash flow problems or even bankruptcy.

When payment is late, chasing payment may result in significant additional costs, such as the cost incurred by using a collections agencies or legal fees. Ultimately, if a debt is uncollectable, it must be written off and therefore becomes a liability on the balance sheet. This type of debt is known as ‘bad debt’.

Late payment and non-payment of invoices resulting in bad debt can result in significant challenges for the businesses left out of pocket. It can increase Days Sales Outstanding (DSO), harm cash flow, and damage credit score.

How to avoid accounts receivable turning into bad debt

By ensuring that AR is collected on time, a business can reduce its DSO, maximize cash flow, and obviate the risk of bad debt.

In particular, the following steps can help you to overcome challenges in accounts receivable management, and avoid AR turning from an asset to a liability in the future:

1. Screen potential customers

Establishing effective procedures around credit management – essentially taking a stricter approach to the provision of credit terms – can minimize the chances of accounts receivable turning into bad debt.

For new customers buying low-volume items on short terms, simple checks – such as following up trade and bank references – may suffice. But for customers wanting to buy high volumes, it may be necessary to carry out full background and credit history checks through a credit reporting agency. Setting reasonable credit limits for new customers and increasing them as they demonstrate reliability can also minimize the likelihood of bad debt.

2. Improve your ongoing risk analysis process

Customers always present risks in one form or another, but strong risk analysis processes can prevent these risks from becoming problematic. By working on improving how they analyze customer risks businesses will be better able to identify individual customers who are struggling to make payments or facing financial difficulties.

This can be done by rethinking the process altogether, establishing a more rigorous and regular approach to risk assessment that screens new and old customers for potential risks.

3. Improve AR processes

By improving their accounts receivable processes, businesses may be able to increase the efficiency of their collections. For example, automation can be used to streamline processes, strengthen internal controls, speed up communication with customers, and reduce the likelihood of mistakes. Automation can also be used to achieve real-time reporting on the status of invoices and payments.

Along with reducing cost and preventing errors, businesses that streamline their AR process with automation also free up their AR staff from repetitive manual tasks, allowing them to focus on higher-value work.

4. Build stronger customer relationships

Companies can also make their collections processes smoother by improving their customer relationships. This, in turn, can increase the likelihood of earlier settlement, speed up dispute resolution, and reduce the risk that customers will default on payments. As such, companies should take steps to improve their customer service and communications.

This approach may also warn companies early of any difficulties customers may face. As such, companies may be able to adopt different measures at an earlier stage, such as reducing credit limits, offering repayment plans, or instigating debt recovery services.

5. Offer early payment discounts

Customers that can access a discount in return for early settlement are incentivized to pay early. Typically calculated as a percentage of the goods and services purchased, the discount amount can vary depending on how early the invoice is paid.

By speeding up collections using a discounting mechanism, businesses can reduce DSO and improve their cash flow. For the customer, meanwhile, early payment discounts result in a lower cost of goods and represent an attractive, risk-free return on cash.

6. Access AR financing

Lastly, companies can use AR financing to release working capital by receiving cash in return for part of their accounts receivable.

AR financing acts as a line of credit backed by outstanding debt. This allows early utilization of capital that would otherwise be unusable until the invoices are settled. As such, AR financing allows a company to focus on maximizing its working capital rather than spending time and effort aggressively chasing customers for prompt payment.