In this article, you will learn:
- What Is Accounts Payable?
- What Is the Role of Accounts Payable?
- What Is the Accounts Payable Process?
- What Is Included in Accounts Payable?
- What is Accounts Payable Turnover?
- How to Record Accounts Payable?
- How to Record Accounts Receivables?
- How to Calculate Accounts Payable?
- Reducing Accounts Payables
- Discounts on Accounts Payable vs Accounts Receivable
- Example of Accounts Payable
- General Ledger Account: Accounts Payable
Trade credit is an essential source of finance for small businesses. It is especially important when firms find it challenging to obtain funding via financial or credit institutions. Since the financial crisis, trade credit in the form of accounts payable and accounts receivable has become a stable source of finance.
It is an important cash management tool and its use is indeed two-fold. You as a business can be viewed as a supplier. And your accounts receivables represent the amount of money you lend to your customers. Likewise, You are also a customer of your vendors. And your accounts payable represent your borrowings from such suppliers.
Therefore, a combination of accounts payable and accounts receivable is important for your business’s performance.
However, in this article, we will talk about accounts payable meaning, accounts payable journal entry, accounts payable process, and accounts payable examples.
What Is Accounts Payable?
Accounts payable refers to the money your business owes to its vendors for providing goods or services to you on credit. Typically, these are the short-term debt that you owe to your suppliers. In other words, the total amount outstanding that you owe to your suppliers or vendors comes under accounts payable. Further, it is represented under current liabilities on your firm’s balance sheet. This is because accounts payable become due for payment within a year.
In addition to this, your cash flow statement represents an increase or decrease in accounts payable in the prior periods. Say your firm’s accounts payable increases as compared to the previous period. This means that your business is purchasing more goods on credit than cash. However, say your accounts payable reduce relative to the previous period. This implies that you are meeting your short-term obligations at a faster rate.
Accordingly, accounts payable management is critical for your business to manage its cash flows effectively.
What Is the Role of Accounts Payable?
- Accounts payable management is essential for you as a small business. This is because it ensures that your accounts payable contributes positively towards your business’s cash flows. That is it helps you to minimize late payment costs like interest charges, penalties, etc.
- Further, it helps to reinvest the funds into your business that you would have otherwise paid to your suppliers. That is accounts payable acts as an interest-free source of finance for your business. Provided these are managed effectively.
- In addition to this, effective accounts payable management practices ensure building trust with your suppliers. That is honoring the agreed payment terms and paying your suppliers on time. Building trustworthy and strong relationships with suppliers are essential. This is because it helps you to receive goods on better credit terms from your vendors.
- Effective accounts payable management also ensures that proper controls are in place. That is it helps in avoiding errors like duplicate payment, inaccurate invoices, fraud by suppliers, inefficient processes, or late payment.
- Accounts payable if managed effectively indicates the operational effectiveness of your business. Too high accounts payable indicates that your business will face challenges in settling your supplier invoices. However, too low accounts payable indicates your business is giving up on the benefits of trade credit.
- Proper accounts payable management helps in organizing and maintaining supplier information and payment terms. This means it ensures that all the vendor invoices, purchase orders, and other expenditures are tracked and paid on time. Furthermore, it will also help in avoiding missing payments.
What Is the Accounts Payable Process?
Streamlining the accounts payable process is an essential aspect of your business growth and development. However, it is often overlooked as managing accounts payable is a backend task. Therefore, you need to make your accounts payable process efficient so that it provides a competitive advantage to your business.
So, the main aim of implementing the accounts payable process is to pay your bills and invoices that are error-free and legitimate.
The accounts payable department of each business may have its own set of procedures in place before making payments to vendors. However, before streamlining your accounts payable process, it is essential to understand what is the accounts payable cycle.
The accounts payable cycle is a part of your purchasing cycle. It includes activities essential to complete a purchase with your vendor. So, considering a complete accounts payable cycle, your accounts payable process must include the following steps.
Capturing Data Through Chart of Accounts
An ideal accounts payable process begins with a proper chart of accounts. A chart of accounts is a statement or report that captures all your accounting transactions including accounts payable. Quickbooks online accounting software categorizes your transactions and breaks them down into various categories. These include assets, liabilities, incomes, and expenses.
Generally, Quickbooks provides a list of standard accounts like accounts payable, accounts receivable, purchase orders, payroll expenses, etc. However, if you do not see an account that you need, you can add your own accounts manually in your chart of accounts.
Therefore, the chart of accounts would help you to track your accounts payable expenses in a proper manner. You can also generate your chart of accounts in Microsoft Excel or Google Sheets.
Add Vendor Details
You need to add details of all your suppliers into your accounting software or Microsoft Excel Sheet in case you are starting your business.
In case you are using online accounting software like Quickbooks, you can add suppliers and details relating to such suppliers into the software itself. These details include address, email Id, contact number, website, tax registration number, etc.
You can also include payment terms agreed upon by the suppliers. These payment terms specify the time period you will take to make payment to your suppliers. The standard payment terms include net 10, net 20, or net 30.
Say, your supplier sends an invoice with payment terms of net 30. Furthermore, the invoice date is October 10. Accordingly, you are required to pay your supplier latest by November 9. Otherwise, it would be considered a late payment.
Besides the above-mentioned payment terms, the other set of standard payment terms include 2/10 net 30. Say we consider the same example as above.
Accordingly, the 2/10 net 30 payment term means you can take a 2% discount on the total due amount. This is if you pay your invoice by October 9. Otherwise, you would have to pay the full amount standing against the due invoice by November 9.
Checking and Filling Invoice Details
You need to check the invoices thoroughly received from your suppliers. Examining invoices is essential to ensure the accuracy of data.
Also, you need to cross-check the goods received from your suppliers with those mentioned in the invoice. Likewise, you need to check whether you have received all the services that were mentioned in the vendor invoice.
Once you review all the received invoices, you can start filling in the invoice details. If your vendors create and send invoices using invoicing software, then the invoice details get uploaded to your accounting software automatically.
However, if your vendors create and send invoices manually, then you need to start filling in the details either in your accounting software or books of accounts.
You need to keep a track of your accounts payable to know when the payments are due. This will help you to make payments to your suppliers on time.
Quickbooks online accounting software allows you to keep a track of your accounts payable that are due for payment.
This can be done by generating reports like the Accounts Payable Aging Summary report and Accounts Payable Aging Detail report.
For instance, the Accounts Payable Aging Summary report not only tells you about the vendors to whom you owe money. But, it also reflects the invoices against which your payments are overdue.
If you are using manual accounting software, then you will have to review the due date of each of the invoices.
This is to know the invoices that are due for payment. Once you review all the invoices, the next step is to process payments for those invoices. There are various ways in which you can make payments against the invoices.
- write a check
- pay electronically
- process checks via accounting software
- pay through company credit card
Repeat the Process
You can follow the above procedure either weekly or fortnightly. This to reduce your workload at the month-end. Following a weekly or a fortnightly accounts payable cycle can help you avoid late payments. You must process your invoices on a regular basis despite having few vendors.
What Is Included in Accounts Payable?
Accounts payable refers to the vendor invoices against which you receive goods or services before payment is made against them. That is you purchase goods on credit from your suppliers. Thus, your vendors supplying goods on credit are also referred to as trade creditors.
Since you purchase goods on credit, the accounts payable is recorded as a current liability on your company’s balance sheet. It is important to note that the accounts payable category represents the short-term obligations of your business.
That is, it represents the aggregate amount of short-term obligations that you have towards the suppliers of goods or services. Thus, the accounts payable account also includes the trades payable of your business.
This is because trades payable refers to the amount of money that you owe to your suppliers for products related to inventory.
Inventory includes the raw materials needed to produce goods for sale or finished goods. That is, trades payable is the amount for which you bill your suppliers for those goods or services that you use for the ordinary course of business.
Therefore, if your business has only a few accounts payable, you may record them directly in your general ledger. However, if you have a large number of accounts payable, you may first record the individual accounts payable in a sub-ledger.
A sub-ledger consists of details of all the individual transactions of a specific account like accounts payable, accounts receivable, or fixed assets.
The total of all these individual transactions can then be recorded in the general ledger.
What is Accounts Payable Turnover?
Accounts payable turnover refers to a ratio that measures the speed at which your business makes payments to its creditors and suppliers. Thus, the accounts payable turnover ratio indicates the short-term liquidity of your business. It reflects the number of times your business makes payments to its suppliers in a specific period of time. In other words, the accounts payable turnover ratio signifies the efficiency of your firm in meeting its short-term obligations and making payments to suppliers.
Accounts Payable Turnover Ratio Formula
You need to first calculate the total purchases that you have made from your suppliers. These purchases are made during the period for which you need to measure the accounts payable turnover ratio.
Then, you need to calculate the average amount of accounts payable during such a period. Finally, you can calculate the accounts payable turnover ratio using the following formula.
Accounts Payable Turnover Ratio Formula = Total Purchases from Suppliers/((opening accounts payable + closing accounts payable)/2)
Or Accounts Payable Turnover Ratio = Total Purchases from Suppliers/Average Accounts Payable
Remember, you need to deduct all the cash payments made to the suppliers from the total purchases from suppliers in the above formula. This is because the total supplier purchases should include only the credit purchases made from the suppliers.
Analysis of Accounts Payable Turnover Ratio Formula
Your company is paying slowly to its suppliers if its accounts payable turnover ratio falls relative to the previous period. Such a falling trend in Accounts Payable Turnover Ratio may indicate that your company is not able to pay its short-term debt. In other words, it is facing a financial crunch.
On the other hand, if your business is considered as taking advantage of discounts on early payments if it is paying its suppliers very quickly.
Example of Accounts Payable Turnover Ratio
Robert Johnson Pvt Ltd needs to determine its accounts payable turnover ratio for 2019 It had an opening accounts payable balance of $500,000 and a closing accounts payable balance of $650,000.
In addition to this, Robert Johnson Pvt Ltd made purchases worth $6,000,000 during the year. Therefore, the accounts payable turnover ratio of Robert Johnson Pvt Ltd for 2019 is as follows:
Accounts Payable Turnover Ratio = $6,000,000/(($500,000 + $650,000)/2)
= 10.43 times
Thus, this means that Robert Johnson Pvt Ltd paid 10.43 times to its suppliers during the year. Further, you can also calculate the Accounts Payable Turnover Ratio in days. This ratio showcases the average number of days after which you make payments to your suppliers.
Thus, the formula for Accounts Payable Turnover Ratio in days is as follows.
Accounts Payable Turnover Ratio in days = 365/Accounts Payable Turnover
= 34.98 days
This means that Robert Johnson Pvt Ltd makes payments to its suppliers approximately after 35 days.
How to Record Accounts Payable?
As mentioned earlier, accounts payable refer to the total short-term obligations of your business towards its creditors or suppliers. That is, these obligations need to be met in less than a year. Therefore, accounts payable appears on the liability side of your balance sheet, under current liabilities.
So, whenever your supplier provides goods or services on credit to your business, there are accounts payable outstanding on your balance sheet. This means the accounts payable account gets credited as there is an increase in the current liability of your business.
Since we typically follow a double-entry bookkeeping system, there has to be an offsetting debit entry to be made in your company’s general ledger. Thus, either an expense or an asset forms part of the debit offset entry in case of accounts payable.
Example of Accounts Payable
Say, Robert Johnson Pvt Ltd purchased goods worth $200,000 on credit from its supplier. It would record the following journal entry on receipt of goods on credit from its supplier.
|Purchases account (Dr.)||$200,000|
|To Accounts Payable (Cr.)||$200,000|
When Robert Johnson Pvt Ltd makes payment to its supplier, the accounts payable account gets debited. This is because Robert Johnson’s current liability reduces by $200,000. The offsetting credit entry for such a transaction is made to the cash account. This is because cash worth $200,000 gets reduced.
So, the following is the journal entry for cash paid to the supplier.
|Accounts Payable account (Dr.)||$200,000|
|To Cash (Cr.)||$200,000|
How to Record Accounts Receivables?
Let’s consider the above example again to understand how to record accounts receivable.
When Goods are Sold on Credit
As per the above example, Robert Johnson Pvt Ltd sold worth $300,000 paper to James & Co. on a 45-day period credit. The journal entry at the time the invoice is raised would be as follows:
|Accounts Receivable A/c Dr||$300,000|
|To Sales Cr||$300,000|
Thus, debiting Accounts Receivable with $300,000 means an increase in Accounts Receivable by the same amount. Likewise, crediting the Sales Account by $300,000 means an increase in Sales by the same amount.
When Cash is Received for Goods Sold on Credit
In the above example, James & Co. paid $300,000 in cash to Robert Johnson Pvt Ltd within 45 days. The journal entry at the time cash is received for goods sold on credit would be as follows:
|Cash A/c Dr||$300,000|
|To Accounts Receivable Cr||$300,000|
As per the above journal entry, debiting the Cash Account by $300,000 means an increase in Cash Account by the same amount. Likewise, crediting Accounts Receivable by $300,000 means a decrease in the Accounts Receivable by the same amount.
How to Calculate Accounts Payable?
You can calculate the accounts payable by generating accounts payable aging summary report. This is in case you are using Quickbooks Online accounting software. This report gives a summary of all the accounts payable balances. It also lets you know about the balances that are overdue for payment.
If you do not have accounting software, you can calculate your accounts payable by adding the amounts of all the bills that you have maintained physically.
Below is the balance sheet of Walmart Inc as of January 31, 2020. It showcases that the accounts payable of Walmart Inc were $46,973 million in 2020 and $47,060 million in 2019. Thus, an investor or an outsider can calculate days payable outstanding in order to know the number of days Walmart Inc takes to clear its accounts payable.
Furthermore, based on Walmart’s payment schedule, its suppliers can determine the credibility of the company. For instance, the suppliers would consider Walmart Inc to be a credible customer if it pays its suppliers within a decent credit period.
Also, days payable outstanding of Walmart Inc would also help the company in ensuring that it is neither paying too early or too late to its suppliers.
Delaying the payments for a few days would help Walmart Inc to hold more cash and thus eventually pay to its suppliers.
However, delaying payments for a long period would critically impact Walmart’s relationship with its suppliers.
Reducing Accounts Payables
Your business must focus on optimizing its accounts payable and thus free up working capital to enhance business growth. An ineffective accounts payable management can lead to invoices not being processed on time. Or losing out on the opportunity to avail discounts.
Following are some of the strategies that you can adopt to optimize your business’s accounts payable.
Choose Preferred Suppliers
You need to set up a list of favored suppliers. This is to promote moderate and favorable buying from your suppliers. Such a list can be developed considering certain factors. These include the supplier’s performance, his financial soundness, brand identity, and his capacity to negotiate.
Review Supplier Contracts Regularly
It is essential for you to review your supplier contracts on a regular basis. This is because it will help you to prevent fraudulent billing practices. These could be overpayment or duplicate payment.
Therefore, to carry out such a practice, you need to ensure that you have a proper accounts payable team. Such a team reviews supplier data for its completeness, accuracy, and compliance with standard terms.
Besides this, you also need to include certain clauses in the supplier contract relating to penalizing suppliers. This is in case of non-performance or underperformance.
Pay Accounts Payable Early
Paying accounts payable on time would strengthen your company’s relationship with your suppliers. In return, the suppliers would offer attractive discounts so that you can save more and stay connected with the supplier.
Use Accounts Payable Software
You need to ensure that a centralized invoice processing system is at the place. An Online Invoicing Software like Quickbooks helps you to automate your accounts payable process by going paperless. That is, all your company’s bills can be created and sent via the invoicing software.
Hence, there is no need for you to manually enter or upload all your invoices. Besides this, your purchase and payment process would also get automated.
Discounts on Accounts Payable vs Accounts Receivable
If you are a credible customer for your supplier, you can receive early payment discounts on your accounts payable. Likewise, you can also offer discounts to your customers so that they can make early payments against the accounts receivable.
Thus you can receive a discount on your accounts payable and you can give a discount on your accounts receivable. Both accounts payable and accounts receivable form an important part of trade credit.
It is important for your business to receive trade credit from its suppliers in the form of accounts payable. This is to finance your production process. However, it is also important to extend trade credit in the form of accounts receivable to sell goods to your customers.
Methods to Pay Early Discounts
There are two methods to pay and record discounts:
Under the Net Method, if you pay your supplier within the agreed-upon time period, you get a certain percentage of the discount. This is before the payment becomes due.
For instance, 20/10 net 30 is a trade credit that your suppliers offer for the sale of goods or services. This means that you will receive a discount of 2% if you pay the amount due within 10 days. Otherwise, the amount gets due within 30 days.
Considering the above example, say Robert Johnson Pvt Ltd makes a purchase of $10,000 from its supplier James and Co. This is done on a credit term of 2/10 net 30. The following is the journal entry for the same in the books of James and Co:
|Accounts Payable Account Dr.||$9,800|
|To Sales Cr.||$9,800|
Say Robert Johnson Pvt Ltd pays cash within 10 days to take advantage of a 2% discount. In that case, the journal entry in the books of James and Co would be as follows.
|Accounts Payable Account Dr.||$9,800|
|To Sales Cr.||$9,800|
Now, the journal entries in the books of Robert Johnson Pvt Ltd would be as follows.
|To Accounts Payable Cr.||$9,800|
|Accounts Payable Account Dr.||$9,800|
|To Cash Cr.||$9,800|
The Gross Method records the total value of receivables in case you take advantage of the discount from your supplier. Accordingly, James and Co. will reduce its revenue in the income statement. Following are the journal entries in the books of James and Co.
|Accounts Receivable Account Dr.||$10,000|
|To Sales Cr.||$10,000|
Say Robert Johnson pays James and Co. within 10 days. In this case, the journal entry in the books of James and Co would be as follows.
|Cash a/c Dr.||$9,800|
|Cash discount a/c Dr.||$200|
|To Accounts Receivable Cr.||$10,000|
Likewise, the following entries would be showcased in Robert Johnson’s books of accounts.
|Accounts Payable Account Dr.||$10,000|
|To Cash Discount Cr.||$200|
|To Cash Cr.||$9,800|
General Ledger Account: Accounts Payable
Accounts payable is a general ledger account that showcases the amount of money that you owe to your creditors/ suppliers. Say you receive an invoice mentioning the payment terms from your supplier. Whenever you receive such an invoice, it gets recorded in your accounts payable ledger.
As a result, your total liabilities also increase with the same amount. Now, the accounts payable represent the short-term debt obligations of your business. Hence, they form a part of the current liabilities on your company’s balance sheet.
Accordingly, accounts payable has a credit balance since it is your current liability. This means the accounts payable balance would increase if there is a credit entry. However, the accounts payable balance would decrease if there is a debit entry.
Say, for instance, you receive invoices from your suppliers. These supplier invoices would be recorded as credits to your accounts payable account.
As a result, such a transaction would increase the credit balance of your accounts payable. When you eventually pay your suppliers in cash, your accounts payable balance gets reduced. This happens with the debit of the accounts payable account.
What Does an Accounts Payable Clerk Do?
There are a number of duties that the accounts payable clerk performs. He keeps a track of all the payments and expenses and maintains records. Further, the clerk undertakes the processing, verifying, and reconciling the invoices. Also, he pays vendors by scheduling pay checks and ensures that payment is received for outstanding credit.
What is the Result of an Increase in Accounts Payable During a Period?
An increase in the accounts payable indicates an increase in the cash flow of your business. This is because when you purchase goods on credit from your suppliers, you do not pay in cash. Thus, an increase in accounts payable balance would signify that your business did not pay for all the expenses. These expenses form part of your current period’s income statement.
What is Accounts Payable on a Balance Sheet?
Accounts payable forms a part of the current liabilities in your company’s balance sheet. This is because accounts payable represent the short-term debt obligations of your business. And these obligations must be met within a year. Thus, an increase in accounts payable would mean that your business is buying more goods on credit than in cash.
What is Accounts Payable Turnover?
The accounts payable turnover refers to a ratio that measures how quickly your business makes payment to its suppliers. That is, it indicates the number of times your business makes payments to its suppliers in a specific period of time. Thus, the accounts payable turnover ratio demonstrates your business’s efficiency in meeting its short-term debt obligations.
What is the Difference Between Accounts Receivable and Accounts Payable?
Accounts receivable refers to the amount that your customers owe to you for the goods and services provided to them on credit. Thus, the accounts receivable account gets debited and the sales account gets credited. This indicates an increase in both accounts receivable and sales account. Further, accounts receivable are recorded as current assets in your company’s balance sheet. On the other hand, accounts payable refers to the amount you owe to your suppliers for goods or services received from them. Thus, the purchases account gets debited, and the accounts payable account gets credited. Furthermore, it is recorded as current liabilities on your company’s balance sheet.
When Confirming Accounts Payable, Emphasis Should be Put on What Kind of Accounts?
When confirming accounts payable, your company’s auditors must take a sample of accounts payable. These majorly represent your business’s purchasing or borrowing activities. Further, special emphasis must be given to accounts payable representing larger transactions. Once the sample invoices are reviewed, each of them must be confirmed and verified. This can be done by comparing invoices with company records. You must also review and verify loans, principal balance, and interest rate. This is because few of the accounts payable can also include loans and interest payments.
Why are Accounts Payable and its Management Important?
Accounts payable and its management is important for the efficient functioning of your business. Such a process would ensure that your bills are paid on time. As a result, the suppliers would provide goods or services without any interruption. Also, an efficient accounts payable management process prevents fraud, overdue charges, and better cash flow management. Further, it also ensures proper invoice tracking and avoiding duplicate payment.