How does accounts receivable work?

Accounts receivable refers to the money due to you from customers or clients. On your balance sheet, accounts receivable (AR, also called trade debtors) is a current asset. You will only have an accounts receivable process if you extend credit to your customers. For instance, professional services businesses often have accounts receivable because they don’t collect final payment until after their services have been completed.

Businesses that commonly carry accounts receivable include architecture and engineering firms, builders and trades, transport businesses and consulting firms. Many small businesses also extend credit to clients when they’re getting started.

Staying on top of AR is an important part of any bookkeeping practice. Learn more about accounts receivable and how it can keep your cash flow going.

What is accounts receivable?

The accounts receivable line in your accounts is the total amount customers owe you for sales you have invoiced but not yet been paid for. Many businesses offer customers 14 or 30 days to pay, and some offer 60. This means that once you send your invoice, the customer has that many days to pay it. In the meantime, the amount is accounts receivable.

Is accounts receivable an asset or liability?

Since accounts receivable represents future incoming cash, it is an asset. That said, if you are unable to collect the money due to you, an amount in accounts receivable can become a bad debt.

The accounts receivable process

How does accounts receivable work? Let’s talk about what you need to do to establish a process that works for your organisation. The key is to balance your need for cash flow with an appropriate level of flexibility for clients.

Establish credit practices

Before you offer credit to your clients, set your rules and put them in your contract or terms of trade. That way clients know when they must pay, and you can charge late fees only if they agreed to them up front.

Your business should decide:

• How much credit are you willing to extend to clients? Agree a suitable deposit, payment milestones or credit limit, subject to industry and state rules. For example, current Victorian domestic-building deposits are capped at 10% below a $20,000 contract value and 5% at $20,000 or more; a universal 50% deposit would be wrong. Identify the amount of credit you’re comfortable extending and put it in writing.
• Is every client creditworthy? Decide which clients can pay on account, and check new clients (for example their ABN and trading history) before you extend credit.
• How long will people have to pay? Common terms are 7, 14 or 30 days. In building, construction and related design or supply work, state security of payment laws cap payment times (in NSW 15 or 20 business days after a payment claim) and give you a statutory payment-claim and adjudication process; check your state's Act. The longer the terms, the longer you wait for your cash.
• Will you charge late fees or interest? If so, set them out in your terms and conditions before work begins. In Australia there is no general right to charge interest on a late business invoice unless the agreement allows it. You may also want to consider a discount for paying early.

Invoice your customers

Once you have established credit practices and agreed terms with a client, you need an invoicing process. Send your customers or clients an invoice as soon as your work is complete. This starts the clock on their payment period. Invoicing late delays your incoming payment.

Track your accounts receivable

You need to stay on top of what you are owed. Many businesses appoint someone to look after accounts receivable as they grow. Your accounting software can produce an aged receivables report, which groups unpaid invoices by how overdue they are (for example current, 1 to 30 days, 31 to 60 days and over 60 days). Review it every week.

For every invoice, your accounts receivable team should be tracking:

• The amount due
• The date the client was invoiced
• The invoice due date
• The dates the client was contacted about overdue payments
• Any late fees that your terms allow
• Any dispute raised by the client
• Escalation steps taken to collect payment

Accounts receivable accounting

Accounts receivable is part of your balance sheet, the report that lists your business’s assets, liabilities and equity at a point in time. Under accrual accounting, recognise revenue when or as the relevant performance obligation is satisfied. For an invoiced sale already earned, debit accounts receivable and credit revenue, with GST recorded separately where applicable. An advance invoice may instead credit a contract liability until the work is delivered. When the client pays an existing receivable, debit the bank and credit receivables: that payment converts a receivable to cash and does not create revenue again.

For example, you invoice a client $11,000 including $1,000 GST. You debit accounts receivable $11,000, credit sales $10,000 and credit GST payable $1,000. When the client pays, you debit the bank $11,000 and credit accounts receivable $11,000.

Under cash accounting, income is recorded only when the money arrives, but you still need to keep track of unpaid invoices so you know who owes you what. If you account for GST on a non-cash (accruals) basis, for an ordinary taxable sale you report GST in the earlier period of issuing an invoice or receiving any consideration, subject to applicable special rules. This differs from the timing of revenue recognition.

The difference between accounts receivable and accounts payable

While accounts receivable reporting shows money that is due to you, accounts payable is just the opposite. Accounts payable are debts that you owe to someone else in the short term. For example, when a plumber fixes a leaking pipe at your office, they leave an invoice. You record the debt in accounts payable and pay it within the agreed time.

Accounts receivable comes from your sales, services and other client work. Accounts payable covers everything from utilities and rent to supplier invoices. Wages are usually handled separately through payroll rather than as accounts payable.

How do you record accounts receivable?

How does accounts receivable work in your reports? Your balance sheet shows a single total for accounts receivable (trade debtors) under current assets, rather than each invoice.

Behind that total, your accounting software (or, for a very small business, a spreadsheet) keeps each invoice separately. The aged receivables report adds up to the balance sheet total, and granular tracking lets you follow up overdue invoices one by one.

What happens if a client doesn’t pay?

Unfortunately, some clients will pay late. Ordinary contractual late fees or interest should be agreed in your contract or terms of trade. Statutory and court-awarded interest are separate; NSW security-of-payment law, for example, provides interest on overdue progress payments at the greater of the contract rate and applicable court-rule rate. Keep it proportionate: a fee far out of line with the cost the late payment causes you can be challenged as an unenforceable penalty, and in a standard form contract with a small business or consumer it may be an unfair contract term, which has been illegal for contracts made, renewed or varied on or after 9 November 2023.

If a client disputes an invoice, stop the reminders while you find out what is wrong, and fix any error quickly. A disputed invoice is a different problem from a slow payer.

For an undisputed late payment, business.gov.au suggests escalating step by step: check your contract, send a friendly reminder, then a letter of demand, then consider mediation or dispute resolution, a debt collection agency and, finally, legal action in a small claims tribunal or court.

If you are unable to collect, the amount may become a bad debt. The ATO allows a tax deduction for a bad debt only if the amount was previously included in your assessable income, it is genuinely unlikely to be recovered, and you decided to write it off and recorded that decision in writing before the end of the income year. If you account for GST on a non-cash basis and have already paid the GST on the sale, you can also claim a decreasing adjustment on your BAS once you write the debt off or it has been overdue for 12 months or more. If the client later pays, you make an increasing adjustment.

Help with accounts receivable

Need help tracking your incoming payments? Visory can provide a bookkeeping team to manage your client invoices and follow up overdue accounts, so you can keep your cash flowing. Learn more about Visory’s accounts receivable services.