So, you've received an order and have sent your customer the product or service they've requested. Congratulations! Next, you need to get the customer to pay. The process of collecting money begins with an invoice sent to the customer showing the amount due and the terms of payment. Preparing an invoice creates an account receivable. This is a thing of value to your business, ranking high on your list of assets since it easily converts to cash.
TL;DR (Too Long; Didn't Read)
In accounting terms, preparing an invoice creates an account receivable. As soon as it's paid, the invoice becomes cash.
Sales Invoice Definition
A sales invoice is a business document that's prepared whenever you need to request payment from a customer for goods or services that you've supplied. The invoice contains important details like the product, quantity, price and terms of payment, such as the company's bank details. As far as documents go, it's one of the easiest to create, and it's also one of the most important. An invoice establishes the customer's obligation to pay. By issuing an invoice, you're verifying the contract that exists between you and the customer and that you've completed your side of the bargain. Once the customer agrees to the invoice, it becomes a legal debt the customer has to pay.
What's the Difference Between an Invoice and a Bill?
It's worth clearing up some terminology at this point because there's often a lot of confusion about what an invoice is and what a bill is. An invoice is always sent from the seller to the customer in the hopes of being paid within a certain amount of time. So, when you're providing goods and services, you'll always create an invoice. A bill is something the customer must pay. So the invoice you've created, on the customer's side of the fence, is a bill. It's the same document but with a different name, depending on whether you're paying or receiving money.
In accounting terms, this distinction is important. Both you and the customer will use the same invoice for bookkeeping purposes. But, whereas the customer will use the invoice to record money that has to leave the business, which is called an account payable, you'll use it to record money that will come into the business, which is called an account receivable.
What Information Must be Present on a Sales Invoice?
Generally, you can break the invoice down into two parts: the invoice header and billing core. The header of the invoice contains:
- The name and address of the seller.
- The name and address of the recipient.
- The date of the invoice – this is vital! The clock starts ticking for the customer on the invoice date. If you have a time limit for payment, which you should, then including a date makes sure everyone's on the same page about when the payment is due.
- A unique invoice number.
- A PO number, if you use a purchase order system to control your business purchases.
The billing core contains:
- A detailed description of the service rendered or the products supplied, including quantities and prices.
- Any applicable sales taxes.
- The total price that's due.
- Terms and conditions for payment. For example, you might specify "net 30," which means the entire amount is due in 30 days.
- The method of payment, such as bank account details or the name of a person where the customer can send checks.
What's a Sales Invoice in Accounting Terms?
Many businesses have a fair number of customers who don't pay immediately. If you use the accrual method of invoice accounting, you'll be recording income when you've earned it, not when the money lands in your bank account. This means you need a method for recording income that you're entitled to receive but that you haven't yet received. A sales invoice in accounting terms is an "account receivable" or "A/R." Accounts receivable represent all the payments that are due to your business that haven't been paid yet by customers.
If you think about it, what you're actually doing when you create an invoice is extending the customer interest-free credit for a short time. You're allowing them to obtain goods or services before payment, based on the trust that payment will be made at payment date. An account receivable is simply a way of recording this trust.
How Do You Record an Invoice?
A/Rs are incredibly valuable to your business because when they're paid, they convert immediately to cash. As such, you'll record them as assets on the company's balance sheet. It's conventional to list assets in order of liquidity, which measures how quickly something can be converted to cash. So, out of all your business assets, cash is the most liquid, and assets like real estate, shares in hedge funds and other alternative investments are the least liquid since these items are much harder to sell.
Accounts receivable are listed as current assets since payment is due from the customer in one year or less. And, because they convert to cash, the moment the invoice is paid, A/Rs are among your most liquid assets. You'll generally list them below cash on the balance sheet, and the figure you insert is simply the total amount of all your outstanding invoices.
What's the Difference Between Accounts Receivable and Accounts Payable?
The flip side of accounts receivable is accounts payable. A/Ps occur when you owe money to your suppliers because you haven't paid the bill yet. As an accounting entry, it represents your obligation to pay off a short-term debt. To illustrate, imagine a supplier sends you a case of widgets and a few days later sends an invoice for the $500 cost. You're obligated to pay this money, so you record the $500 as a debit in the accounts payable column and simultaneously credit $500 for the raw materials expense, which is usually listed as a cost of goods sold. Your supplier is waiting to receive the payment, so it records the invoice in its accounts receivable column.
Then, when you write a check to pay the bill, you'll enter a $500 credit to the accounts payable column and a $500 debit to the checking account. If anyone looks at your income statement, they can see at a glance the total amount the business is carrying in unpaid bills.
What if a Customer Doesn't Pay?
In an ideal world, all your customers would pay all your invoices on time, every time. In the real world, customers pay late and some don't pay at all. The problem here is that your accounts receivable entry is supposed to show the balance of all the invoices that will convert to cash in the near future. If a customer isn't paying for 90, 120 or 360 days – or isn't paying at all – this will distort the accuracy of your balance sheet.
Rule number one of debt collection is that the longer a payment is owed, the harder it is to collect it. One vital calculation for any business is to figure out how old your invoices are by a process called "aging." If you use business accounting software, the usual categories for this type of report include:
- Current: Due immediately.
- 1 to 30 days: Due within the next 30 days.
- 31 to 60 days overdue.
- 61 to 90 days overdue.
- 91 days and over overdue and so on, in 30-day increments.
The purpose of aging is to see which invoices need follow-up, such as calling the customer or sending the account to a collection agency. It also gives some insight into whether you're collecting payments too slowly and taking on too much credit risk. If receivables drip in too slowly, you could wind up with a major cash flow problem and have to borrow money to meet your daily operating expenses.