John Day

Article Summary:

How to setup an account receivable system for your business.

Accounts Receivable System: Understanding The Basics

Deciding to extend credit to customers of your business means you need to be organized. This entails setting up an Accounts Receivable (A/R) system and consistently following all the policies and procedures established to make the system work. This is essential if you want to avoid the disappointing experience of making a sale only to find out later that you are not going receive compensation. For sure, there are going to be customers who flake out on their obligation to pay. However, equally certain is the fact that if you don't follow up in a timely manner with your outstanding A/R customers, you can expect to have many more uncollectible sales than you should have.

Let's take a look at the A/R system. First, you need to understand the five-step A/R formula:

Step 1) You start with last month's ending A/R balance as your current month's beginning balance;

Step 2) Add any new credit sales;

Step 3) Subtract cash receipts from credit customers;

Step 4) Add or subtract any adjustments that are necessary for a particular customer;

Step 5) Total the first four steps to arrive at your new ending A/R balance.

The sequence of these five steps is what occurs in the A/R general ledger account each accounting period. The total A/R ending balance in step five is the figure that appears on the Accounts Receivable line of the Balance Sheet.

The A/R general ledger account is called the "control account" and is a summary of all the A/R activity that occurred during the accounting period, such as, one month, quarter, or year.

The totals in the A/R control account should mirror the total of the individual A/R customer detail ledgers because the same five-step formula is used for each individual customer. The A/R control total on the Balance Sheet should be compared to the customer detail ledger total as a proving step. If they are not the same, then you must find out why.

Your A/R software program will compute all this for you when you enter Sales and Cash Receipts. However, "you" have to enter any "adjustments". This is the place where things can go astray. Some of these adjustments can become quite convoluted and, to be recorded properly, they must be carefully thought out. In addition, you must become familiar with how to enter debit and credit memos in the A/R software program you are using. Issuing refunds, correcting mistakes, recording write-offs for bad debts, etc., can be tricky, especially if you don't do it very often. You must prove your work each month and keep good notes, otherwise not only will your reports not match up, but your customers will get irritated when you try to collect a balance that is inaccurate.

After all the adjustments are made at the end of the accounting period, a report called the Accounts Receivable Aged Invoice Report should be run. This report tells you, by customer, how much is owed and how old the outstanding balance is. The total of this report should be the same amount found in the A/R control account on the Balance Sheet and in the Customer Detail report.

If you use all three reports to prove your ending balances, and you take the time to clean up any discrepancies "as they arise", your A/R system should always remain accurate.

John W. Day, MBA is the author of two courses in accounting basics: Real Life Accounting for Non-Accountants (20-hr online) and The HEART of Accounting (4-hr PDF). Visit his website to download for FREE his 3 e-books pertaining to small business accounting and his monthly newsletter on accounting issues. Ask John questions directly on his Accounting for Non-Accountants blog.

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