Accounts Receivable and Accounts Payable: Meaning, Formulas, Aging and Bad Debts (2026)

Accounts receivable and accounts payable are the two sides of trade credit. When you deliver now and bill later, the customer owes you money; when a supplier does the same for you, you owe them. These two balances decide how much cash your business actually has, which is why a profitable company can still run out of money. This guide is for owners, bookkeepers and new finance staff in US small businesses. It explains what each term means, how they differ, how to measure them with DSO and DPO, how to read an aging report, how bad debts are treated for tax, and how to collect faster. Tax rules were checked against IRS guidance in October 2026.

Quick answer

Accounts receivable (AR) is money customers owe you for goods or services already delivered; it is a current asset. Accounts payable (AP) is money you owe suppliers for goods or services already received; it is a current liability. Track AR with days sales outstanding (DSO) and AP with days payable outstanding (DPO).

• DSO = receivables ÷ credit sales × days in the period

• DPO = payables ÷ cost of goods sold × days in the period

• An aging report groups unpaid invoices by how overdue they are

• Unpaid invoices are tax-deductible bad debts only if you already reported them as income (accrual method)

• Invoice fast, set clear terms and follow up on a fixed schedule to lower DSO

What accounts receivable means

Accounts receivable is the total of unpaid customer invoices at a point in time. It arises whenever you sell on credit: a plumber who finishes a job and emails an invoice due in 30 days, a wholesaler who ships pallets on net 45 terms, or a consultant who bills monthly in arrears. Until the customer pays, the amount sits in accounts receivable.

On the balance sheet, AR is a current asset because you expect to turn it into cash within a year, usually within weeks. It is shown net of an allowance for amounts you do not expect to collect, so a business with $70,000 of invoices outstanding and a $4,000 allowance reports net receivables of $66,000. Receivables are often a small business's largest asset after cash, and lenders look at them closely; a business line of credit or invoice financing is frequently secured by them.

Recording AR follows the sale. Under accrual accounting, when you issue a $5,000 invoice you record revenue of $5,000 and increase accounts receivable by $5,000. When the customer pays, cash goes up and AR goes down by the same amount, with no further revenue. That is why a growing AR balance means sales have been booked that have not yet turned into cash.

Accounts receivable is different from notes receivable, which are formal written promises to pay, often with interest and longer terms. It is also different from other receivables, such as a tax refund due or an advance to an employee, which accountants keep in separate accounts so that the trade AR figure reflects customer credit only.

What accounts payable means

Accounts payable is the mirror image. It is the total of bills from suppliers and vendors that you have received and not yet paid: inventory purchases, raw materials, contractor invoices, utilities, software, rent and professional fees billed on terms. Cornell's Legal Information Institute describes it as money a business owes for products or services it has already received, recorded as a short-term obligation and cleared when paid.

On the balance sheet, AP is a current liability. When a $3,000 supplier invoice arrives for materials, an accrual-basis business records the expense or inventory and increases accounts payable by $3,000. Paying the bill reduces cash and AP. Accounts payable does not include loans, credit card balances or payroll taxes, which have their own liability accounts.

Good AP practice is about control as much as timing. Most businesses use a three-way match before paying: the purchase order shows what was ordered, the receiving record shows what arrived, and the invoice shows what is billed. Paying only when all three agree stops duplicate payments, overbilling and fake-vendor fraud. Collect a Form W-9 from each new vendor before the first payment, because you need its taxpayer details if you must issue a Form 1099; for payments made from 2026 the 1099-NEC reporting threshold rose to $2,000, up from $600.

Accounts receivable vs accounts payable

The simplest way to remember the difference: receivable means you will receive cash, payable means you will pay it. Every credit transaction creates both at once, on two different companies' books.

Accounts receivable vs accounts payable

Point	Accounts receivable (AR)	Accounts payable (AP)
Meaning	Customers owe you	You owe suppliers
Balance sheet	Current asset	Current liability
Created by	Your sales invoice	A supplier's invoice to you
Cash effect when settled	Cash comes in	Cash goes out
Key metric	Days sales outstanding (DSO)	Days payable outstanding (DPO)
Goal	Collect as fast as terms allow	Pay on time, not early, unless a discount pays
Main risk	Bad debts and late payers	Late fees, lost discounts, fraud

Meaning

Accounts receivable (AR)

Customers owe you

Accounts payable (AP)

You owe suppliers

Balance sheet

Accounts receivable (AR)

Current asset

Accounts payable (AP)

Current liability

Created by

Accounts receivable (AR)

Your sales invoice

Accounts payable (AP)

A supplier's invoice to you

Cash effect when settled

Accounts receivable (AR)

Cash comes in

Accounts payable (AP)

Cash goes out

Key metric

Accounts receivable (AR)

Days sales outstanding (DSO)

Accounts payable (AP)

Days payable outstanding (DPO)

Goal

Accounts receivable (AR)

Collect as fast as terms allow

Accounts payable (AP)

Pay on time, not early, unless a discount pays

Main risk

Accounts receivable (AR)

Bad debts and late payers

Accounts payable (AP)

Late fees, lost discounts, fraud

Both feed working capital, which is current assets minus current liabilities. Rising AR ties up cash; rising AP frees it up temporarily. A company that collects in 30 days but pays suppliers in 60 days is partly financed by its suppliers, while one that collects in 60 days and pays in 15 has to fund the gap from its own cash or a loan. The working capital calculator shows the effect for your own numbers.

DSO, DPO and AR turnover: formulas with worked examples

Balances alone do not tell you whether you are collecting or paying well, because a bigger business naturally carries more of both. Ratios that convert balances into days solve that.

Days sales outstanding (DSO)

DSO tells you how many days, on average, customers take to pay. The formula is accounts receivable divided by credit sales for the period, multiplied by the days in the period. Use average receivables (opening plus closing, divided by two) when balances swing, and use credit sales rather than total sales if a meaningful share of customers pays on the spot.

Worked example: a commercial cleaning company had $50,000 of receivables on January 1 and $70,000 on December 31, so average AR is $60,000. Its credit sales for the year were $730,000. DSO = 60,000 ÷ 730,000 × 365 = 30 days. With net 30 terms, customers are paying on time on average. If the same company's DSO rose to 45 days next year, about half a month's sales, roughly $30,000, would be stuck in receivables that used to be cash.

AR turnover

AR turnover is the same information expressed as a frequency: credit sales divided by average receivables. For the cleaning company, 730,000 ÷ 60,000 = 12.2, meaning receivables turn over about twelve times a year. Divide 365 by the turnover and you are back to DSO.

Days payable outstanding (DPO)

DPO measures how long you take to pay suppliers. The usual formula is accounts payable divided by cost of goods sold for the period, multiplied by the days in the period. Some analysts use total purchases instead of cost of goods sold, which is more accurate when inventory changes a lot.

Worked example: a small hardware wholesaler has average payables of $40,000 and annual cost of goods sold of $480,000. DPO = 40,000 ÷ 480,000 × 365 = 30.4 days. If its suppliers offer net 45, it is paying about two weeks early and could keep that cash longer without harming relationships, unless it is earning early-payment discounts.

Putting them together: the cash conversion cycle

The cash conversion cycle combines both with days inventory outstanding (DIO): DIO + DSO − DPO. If the wholesaler holds stock for 45 days, collects in 30 and pays in 30.4, its cycle is 45 + 30 − 30.4 = 44.6 days. That is how long each dollar spent on inventory is tied up before it comes back as cash. Shortening DSO by ten days cuts the cycle by ten days, which for a business with $730,000 of credit sales frees about $20,000 of cash.

Worked example results

30 days

DSO

$60,000 AR ÷ $730,000 credit sales × 365

12.2×

AR turnover

$730,000 ÷ $60,000

30.4 days

DPO

$40,000 AP ÷ $480,000 COGS × 365

44.6 days

Cash conversion cycle

45 DIO + 30 DSO − 30.4 DPO

The accounts receivable aging report

An aging report lists every unpaid invoice by customer and sorts the amounts into buckets based on how long they are past due. Every accounting package produces one, and it is the single most useful collections document you have. It shows which customers to call today, which ones to put on credit hold, and how much of your receivables is at real risk.

Here is a sample report for a business with $70,000 of receivables, with the loss percentage an accountant might apply to each bucket when estimating the allowance for doubtful accounts. The percentages are illustrative; your own should come from your collection history.

Reading it: 81% of the balance is current or less than a month late, which is healthy. The $7,000 more than 60 days late is where the effort should go, and the $4,000 over 90 days deserves a direct conversation, a payment plan or a decision on whether to stop supplying that customer. The allowance of $4,220 is what the business would show against receivables on its financial statements.

For businesses that prepare financial statements under US GAAP, the allowance follows the current expected credit loss model in ASC 326. A recent change makes this easier for receivables from customer contracts. ASU 2025-05, issued in July 2025, lets any entity assume that conditions at the balance sheet date stay the same over the short life of current receivables, rather than building an economic forecast, and lets private companies also consider cash collected after year-end but before the statements are issued. It applies to annual periods beginning after December 15, 2025, so a calendar-year private company first uses it for its 2026 statements unless it adopted early. The aging method above fits comfortably within that approach.

Bad debts: when you can write off unpaid invoices for tax

The book allowance and the tax deduction are different things. For federal income tax, the allowance method is not used; a business deducts specific debts when they become worthless, under Internal Revenue Code section 166. The IRS calls this the specific charge-off method, and it is the method most businesses must use.

The first rule decides everything: you can deduct a business bad debt only if the amount was already included in your income. Accrual-method businesses record income when they invoice, so an invoice that later proves uncollectible can be deducted. Cash-method businesses report income only when paid, so an unpaid invoice was never income, and the IRS does not allow a bad debt deduction for it. For a cash-basis freelancer, an unpaid invoice is simply income never received.

The second rule is timing. You deduct the debt in the year it becomes worthless, and you do not have to wait until it is due to show that. The IRS says you only need to show that you took reasonable steps to collect and could not. Business bad debts can be deducted when wholly or partly worthless, but a partly worthless debt is deductible only up to the amount you actually charged off on your books that year. For a totally worthless debt no book charge-off is strictly required, though making one protects you if the IRS later decides the debt was only partly worthless. Sole proprietors claim business bad debts on Schedule C; other businesses use their own return.

Writing off a business bad debt (accrual method)

1. 1

   Confirm the amount was reported as income

   Check that the invoice was included in gross income in this or a prior year. Cash-method businesses stop here: there is no deduction.

2. 2

   Document your collection efforts

   Keep reminders, call notes, demand letters, collection agency reports or bankruptcy notices showing the debt cannot be collected.

3. 3

   Charge it off in your books

   Write off the specific invoice, in full or the uncollectible part, in the year it becomes worthless.

4. 4

   Deduct it on your return

   Report it on Schedule C or your business return for that year.

5. 5

   Report any later recovery

   If the customer later pays, include the recovered amount in income, up to the amount that reduced your tax.

A worked example: an accrual-basis marketing agency invoiced a client $8,000 in November 2025 and included it in its 2025 income. In 2026 the client files for bankruptcy and the trustee indicates unsecured creditors will receive nothing. The agency charges off the $8,000 and deducts it on its 2026 return. If in 2027 it unexpectedly receives $3,000 from the bankruptcy estate, it reports $3,000 as other income in 2027.

If you missed a deduction, you can amend. For a totally worthless debt, the deadline to claim a refund is the later of 7 years from the original due date of the return or two years from when you paid the tax, which is why the IRS suggests keeping bad debt records for 7 years. A partly worthless debt follows the normal three-year window. Some service businesses in health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting, and accrual-basis businesses within the small-business gross receipts limit, can instead use the nonaccrual-experience method, which lets them skip accruing service receivables that experience shows will not be collected.

Debts that do not arise from your trade or business, such as a personal loan to a friend, are nonbusiness bad debts. They are deductible only when totally worthless and are reported as short-term capital losses on Form 8949, with a statement attached.

Cash vs accrual: does your business even have receivables?

Under the cash method, you record income when you receive it and expenses when you pay them, so your tax books have no receivables or payables at all. Many sole proprietors and small service firms use it because it is simple and matches the bank balance. Under an accrual method, you record income when it is earned, meaning when all events fixing your right to it have occurred and the amount can be determined, and expenses when incurred. Accrual books carry AR and AP and show profit more accurately.

The IRS limits who can use the cash method. C corporations, partnerships with a C corporation partner, and tax shelters generally cannot, unless they pass the section 448 gross receipts test: average annual gross receipts for the prior three years not exceeding the inflation-adjusted limit, which is $32 million for tax years beginning in 2026. Qualified personal service corporations can also use the cash method. Businesses that sell merchandise were traditionally required to use accrual for purchases and sales, but small business taxpayers under the same limit can choose simpler inventory treatment.

Even if you file taxes on the cash method, track receivables and payables in a management report. You cannot manage collections you are not measuring, and many small businesses keep cash-basis tax books with an accrual-style aging report alongside.

Collections best practices that actually lower DSO

Most late payment is not refusal to pay; it is invoices that are late, unclear or easy to put off. The fixes are operational.

Invoice the day the work is done or the goods ship. Every day between delivery and invoice adds a day to DSO. Use a template with your legal name, invoice number, date, due date, clear description, purchase order number if the customer uses one, and payment instructions; our invoice generator and guide to making an invoice cover the details.

Set and state terms before the work starts. Agree net 15 or net 30 in the quote or contract, along with any late fee, and confirm the customer's accounts payable contact and approval process. Large customers often pay only invoices that carry a valid purchase order number.

Make paying easy. Offer ACH and card payment links on the invoice. Card fees cost money, but a payment in three days rather than forty-five is often worth it; run the numbers with the payment fee calculator.

What does a card or ACH payment link cost you?

I chargeI want to receive

AmountPercentage FeeFixed Fee

Amount Charged₹1,000.00

Processing Fee₹29.30

Effective Fee Rate2.93%

You Receive₹970.70

Open the full Payment Processing Fee Calculator (PDF, save, compare)

Follow up on a fixed schedule. A friendly reminder a few days before the due date, another on the due date, a firmer note at seven days late and a phone call at fifteen days works better than sporadic chasing. The payment reminder generator produces ready-to-send messages.

Use early-payment discounts carefully. Terms of 2/10 net 30 give the customer 2% off for paying 20 days early. That looks small, but the annualized cost is about 2 ÷ 98 × 365 ÷ 20 = 37%, which is far more than most lines of credit. Offer it only if cash is critical. On the AP side, the same math says that if your suppliers offer 2/10 net 30, taking the discount is usually one of the best returns available.

Check credit and take deposits. Ask new business customers for trade references, set credit limits, and take deposits or progress payments on large or custom jobs. Put customers who are 60 days late on hold for new orders until they catch up.

Know your escalation options. When reminders fail, a formal demand letter, a collection agency, small claims court or, for business-to-business invoices, factoring the receivables are the usual next steps. Late fees and interest must be in your contract and within state law to be enforceable.

Monthly accounts receivable routine

0/7

• Run the aging report and review every invoice over 30 days
• Call customers with balances over 60 days and agree a payment date
• Put customers over 90 days on credit hold
• Match every deposit to its invoice and clear unapplied cash
• Calculate DSO and compare it with your terms
• Review the allowance and charge off debts proven uncollectible
• Keep collection records for bad debt deductions

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Common mistakes

Treating AR as cash. A large receivables balance is not money in the bank. Plan spending from your cash forecast, not from booked sales.

Letting unapplied payments pile up. A customer payment that is not matched to an invoice makes the aging report wrong and leads to chasing customers who have already paid. Apply cash weekly.

Deducting unpaid invoices on the cash method. This is the most common bad debt error on small business returns. If you never reported the income, there is nothing to deduct.

Paying suppliers too early without a discount. Paying a net 45 bill on day 10 gives away 35 days of free financing. Schedule payments for the due date unless you earn a discount.

Skipping vendor checks. Without a three-way match and a W-9 on file, duplicate and fraudulent payments slip through, and year-end 1099 reporting becomes a scramble.

Official guidance

• IRS Topic 453 — Bad debt deduction
• IRS Publication 334 — Tax Guide for Small Business (bad debts)
• IRS Publication 538 — Accounting Periods and Methods
• IRS — How long should I keep records?

What to do next

Run your aging report today and calculate DSO and DPO with the formulas above. Then tighten the basics: send invoices with the invoice generator, automate reminders with the payment reminder generator and check your cash position with the working capital calculator. If slow collections leave a gap, compare a business line of credit with invoice financing, and collect a Form W-9 from every new vendor before you pay them.

This is general information, not legal or tax advice — confirm on the official source or with a professional.

Frequently asked questions

What is accounts receivable in simple terms?

Accounts receivable is the money customers owe your business for goods or services you have already delivered but not yet been paid for, usually under an invoice with terms such as net 30. It is recorded as a current asset on the balance sheet because you expect to collect it within a year.

What is accounts payable?

Accounts payable is the money your business owes suppliers for goods or services it has already received but not yet paid for. It is a current liability on the balance sheet. Your supplier records the same amount as accounts receivable, so one company's payable is another company's receivable.

Is accounts receivable an asset or a liability?

Accounts receivable is a current asset. It represents a legal right to collect cash. Accounts payable is the opposite: a current liability, because it is an obligation to pay cash. Neither is revenue or an expense by itself; under accrual accounting the revenue or expense was recorded when the invoice was raised.

How do you calculate days sales outstanding?

DSO equals accounts receivable divided by credit sales for the period, multiplied by the number of days in the period. With $60,000 of average receivables and $730,000 of annual credit sales, DSO is 60,000 ÷ 730,000 × 365 = 30 days, meaning customers take about a month to pay on average.

Can I deduct unpaid invoices as a bad debt?

Only if you previously reported the invoice as income. Accrual-method businesses can deduct a business bad debt in the year it becomes wholly or partly worthless. Cash-method businesses never reported the unpaid amount as income, so the IRS does not allow a bad debt deduction for it. If you later recover a deducted debt, the recovery is taxable.

What is a good accounts receivable turnover?

There is no universal figure; it depends on your payment terms and industry. A useful test is to compare DSO with your terms. If you offer net 30 and DSO is 32 days, collections are healthy. If DSO is 55 days on net 30 terms, a meaningful share of customers is paying late and your aging report will show where.

Sources & verification

Figures on this page were checked against the sources below when it was last reviewed on 9 October 2026. Each rate and limit is stored once with its own official source and review date, and official update channels are monitored daily so changes are picked up. How we verify

1. 1.Topic No. 453, Bad debt deduction — Internal Revenue Service · accessed 9 October 2026
2. 2.Publication 334, Tax Guide for Small Business — Internal Revenue Service · accessed 9 October 2026
3. 3.Publication 538, Accounting Periods and Methods — Internal Revenue Service · accessed 9 October 2026
4. 4.Questions and answers about the limitation on the deduction for business interest expense — Internal Revenue Service · accessed 9 October 2026
5. 5.How long should I keep records? — Internal Revenue Service · accessed 9 October 2026
6. 6.FASB amends guidance on the measurement of credit losses for accounts receivable and contract assets — Deloitte (DART) · accessed 9 October 2026
7. 7.Accounts payable — Legal Information Institute, Cornell Law School · accessed 9 October 2026