Accounts receivable is a basic accounting word but its definition is often explained in a confusing way. In this post, you’ll have accounts receivable explained in a way where you can finally understand its meaning – both the big picture and in detail.
If you want to skip the reading, here’s a quick video (3:04) that explains what accounts receivable is and why it’s important in accounting:
The best way to explain the meaning of accounts receivable is to show through example.
Say you go out and buy a coffee but forgot your wallet at home and can’t pay.
The shopkeeper says “That’s ok mate, I’ll just put $4 for the coffee on your account and then you can pay me later”.
So you get your coffee, and the coffee shop owner gets an invisible “I owe you” from you, his customer (because you haven’t paid him now but owe him this money which he expects you to pay him later).
When he goes on to the accounting system to record this sale, the system records the “I owe you” in two places - one on the left side and the other on the right side of a database (just think of an Excel spreadsheet where you have two cells only) – like this:
On the right side, the accounting system puts $4 it under sales, because the coffee shop owner has made a sale of coffee.
On the other side (left side), the system will put $4 under accounts receivable.
Accounts receivable is a special category (just like sales means that you’ve sold something) that means that this is money that hasn’t been paid yet but is held in this account to remind the coffee shop owner that you, the customer owe him this money.
He is set “to receive” is receivable, and it’s an account, so “accounts receivable”.
In the accounting world, we need to be able to record these “I owe you” from customers because in business, you don’t just get one “I owe you”, usually, businesses gets heaps of “I owe you” (IOU).
Businesses need accounts receivable to keep track of to see who owes them money and then who has actually paid, when they started to owe them money and how long it has taken them to actually pay.
So… lets say you come back after a week and then give the coffee shop owner $4 to pay for the coffee that you had last week.
The coffee shop owner will record this receipt of money in his accounting system and in the back ground, the accounting system will do two things (called database entries) to record it (remember the left and right side).
The system files the $4 in cash account on the left side (that’s a debit) and then files the $4 on other side of accounts receivable (that’s a credit).
So… when you calculate accounts receivable, what you have is $4 going in and then $4 going out so 4 take away 4 is ZERO.
Accounts receivable is now zero because the customer doesn’t own the coffee shop owner any more money because you, the customer have now paid.
Accounts receivable then, is just a place to hold the “I owe you” so a business owner can better manage and track them.
Just think of it as two compartments where on one side, you put in your “I owe you” in one section, and then in the other side, as you get paid your “I owe you” by customers, the amount in your accounts receivable (how much people own you) reduces because they’ve been turned into cold hard cash!
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