What Is Accounts Receivable (AR)? Definition and Examples

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Accounts receivable (AR) is the money customers owe a business for goods or services it has already delivered but has not yet been paid for. Because the customer has a legal obligation to pay, the balance is recorded as an asset, normally a current asset because collection is expected within one year. It appears as “A/R” in accounting shorthand, and individual unpaid invoices are often called “receivables.”

How Accounts Receivable Works

A receivable is created the moment a business earns revenue without receiving cash. A consulting firm invoices a finished project, a wholesaler ships goods to a retailer on 30-day terms, and a utility bills for a month of electricity after supplying it.

In effect, the seller is extending short-term credit to its customer. Terms typically run from a few days to 30, 60 or 90 days, occasionally up to a year, and contracts may charge interest or late fees on overdue invoices. Some businesses offer credit only to frequent or approved customers, who receive periodic statements instead of paying per transaction. Others offer every customer the same invoice terms as standard practice.

Receivables are a product of accrual accounting, which records revenue when it is earned rather than when cash arrives. Under pure cash-basis bookkeeping, a sale is not recorded until the customer pays, so no receivable appears on the books.

The journal entries

A credit sale and its later collection take two entries (hypothetical figures):

1. At the sale: debit accounts receivable $5,000, credit revenue $5,000. The sale shows up on the income statement now, even though no cash has moved.
2. At collection: debit cash $5,000, credit accounts receivable $5,000. Total assets stay the same. One asset (the receivable) turns into another (cash).

This timing gap is why profit and cash flow can diverge. A company can report strong sales while its cash balance falls because the money sits in receivables. When receivables grow over a period, the increase is subtracted from net income in the operating section of the cash flow statement. That is one reason free cash flow can lag reported earnings.

Where receivables sit on the balance sheet

Accounts receivable is listed under current assets, usually after cash and cash equivalents and short-term marketable securities, and near inventory, because it is expected to convert into cash within a year or one operating cycle. Receivables count toward working capital (current assets minus current liabilities).

What Accounts Receivable Can Tell You

The balance alone says little. An AR figure of $2 million is modest for a company with $50 million in annual credit sales and alarming for one with $5 million, so analysts relate receivables to sales.

Accounts receivable turnover

AR turnover = net credit sales ÷ average accounts receivable

Average AR is usually (beginning balance + ending balance) ÷ 2. The ratio shows how many times during the period the company collected its average receivables balance. A higher figure points to faster collection and, often, to customers with better credit quality.

Days sales outstanding (DSO)

DSO = (average accounts receivable ÷ net credit sales) × days in the period

The same result comes from dividing the number of days by the turnover ratio. DSO is the average number of days it takes to collect after a sale. Comparing it with the company’s stated payment terms is revealing. A firm offering 30-day terms with a 55-day DSO has customers paying late, has loose credit policies, or both.

Worked example (hypothetical)

A distributor reports annual net credit sales of $1,200,000. Its receivables were $90,000 at the start of the year and $110,000 at the end.

• Average AR = ($90,000 + $110,000) ÷ 2 = $100,000
• AR turnover = $1,200,000 ÷ $100,000 = 12 times
• DSO = 365 ÷ 12 ≈ 30.4 days

If the distributor sells on net-30 terms, customers are paying close to on time. If the following year DSO rises to 45 days while sales are flat, about $50,000 more cash would be tied up in receivables (assuming the same $1.2 million in sales: $1,200,000 × 45 ÷ 365 ≈ $148,000 average AR versus roughly $100,000). The company might then need to borrow or delay its own payments to cover the gap.

The aging schedule

Internally, companies sort open invoices into buckets by age, such as current, 1 to 30 days past due, 31 to 60 days and over 90 days. Older invoices are less likely to be collected in full. Collections teams use the schedule to decide which accounts to chase, and accountants use it to estimate how much of the balance will never be paid.

When Customers Don’t Pay: Bad Debts and Net Receivables

Not every receivable turns into cash. U.S. GAAP handles this mainly through the allowance method. The company estimates the portion of receivables it expects to go uncollected, records that amount as bad debt expense, and holds it in a contra-asset account called the allowance for doubtful accounts. The balance sheet then shows:

Net receivables = gross accounts receivable − allowance for doubtful accounts

For example (hypothetical), gross receivables of $200,000 and an allowance of $8,000 give net receivables of $192,000. When a specific invoice is confirmed as uncollectible, it is written off against the allowance. The direct write-off method expenses a bad debt only when a specific account proves worthless. It is simpler but records the loss later than the sale that caused it, which is why GAAP generally does not accept it for material amounts.

Before or instead of a write-off, companies can sell overdue or current receivables to a factoring company or debt collector for less than face value, getting cash immediately at a discount. They can also pledge receivables as collateral for a loan, keeping the asset while borrowing against it. Lenders accept receivables for short-term financing because they are relatively liquid.

Accounts Receivable vs. Related Terms

Accounts payable. These are the same transaction seen from the other side. If Company A cleans Company B’s carpets and invoices $3,000, Company A records a $3,000 receivable (an asset) and Company B records a $3,000 payable (a liability). Payables are money a business owes; receivables are money owed to it.

Notes receivable. Accounts receivable arise from ordinary credit sales and are usually supported only by an invoice. Notes receivable are backed by a formal written promissory note, often carry stated interest, and may run longer than a year.

Revenue. Revenue measures what was earned during a period. Accounts receivable measures how much of what was earned remains unpaid at a point in time. A cash sale creates revenue with no receivable.

Deferred (unearned) revenue. This is the reverse timing. The customer pays before the company delivers, so the company records a liability until it performs. A receivable means the company has delivered before being paid.

Inventory. Inventory consists of goods a company holds for sale. Once those goods are sold on credit, they leave inventory (their cost moves to cost of goods sold) and the sale price becomes a receivable. The two are separate current assets.

Limitations of Accounts Receivable

• It is not cash. A receivable is a claim, and its value depends on the customer’s ability and willingness to pay. A large balance concentrated in a few customers carries concentration risk if one of them fails.
• The allowance is an estimate. Net receivables rely on management’s judgment about future defaults. If the allowance is set too low, assets and earnings look stronger than they are.
• Ratios depend on inputs. Companies rarely disclose credit sales separately, so analysts often substitute total revenue, which overstates turnover for businesses with significant cash sales. Seasonal businesses can also show very different balances depending on when the period ends.
• Rising AR can hide problems. Receivables growing much faster than sales may reflect lenient credit terms used to boost reported revenue, or customers falling behind. Either way, the earnings have not yet turned into cash.

The Bottom Line

Business owners, managers and investors can use accounts receivable to judge how quickly reported sales become cash. A growing balance, a rising DSO or a thin allowance for doubtful accounts can mean earnings are running ahead of collections. Relating receivables to credit sales and comparing DSO with payment terms gives a clearer picture than the balance alone.