The basics of Accounts Payable
Accounts payable refers to the amount of money that a company owes to its suppliers for goods received or services rendered. Usually, companies may categorize AP into multiple accounts such as interest, income taxes, or raw materials.
These accounts are created when a company purchases services or goods on credit. The simplest way to think about accounts payable is money that needs to be paid. How a company chooses to pay its outstanding bills (AP) affects its overall cash flow.
Accounts payable must be paid off within a certain period of time to avoid default. The payable part is a short-term IOU. On the other side of the transaction, the party that is owed money would add the same amount to their accounts receivable.
The basics of Accounts Receivable
Accounts receivable is the amount of money owed to a company by its customers. These accounts are recognized as an asset on the balance sheet. These accounts usually involve a single trade receivables account and a non-trade receivables account. When the company transacts with another on credit, they will record an entry to accounts receivable, and the other party will do the opposite.
The turnover ratio of the accounts receivable can determine the strength of a company’s AR. The word “receivable” is used here because the business has a right to “receive”; it has fulfilled its obligation of delivering a product or a service. Accounts receivable represents a line of credit extended by the company.
There is a legal obligation here for the customer to pay their debt, which is why the company can record accounts receivable as an asset. Account balances due from the debtor are usually due in a year or less, depending on the agreed-upon timeframe.
Here are the basics of the accounts receivable process:
- An invoice is sent to the customer.
- Invoices are then tracked, and reminders are sent out.
- When payments have been received, they are recorded as paid and recognized as revenue.
How Accounts Payable and Accounts Receivable are different
These two types of accounts are similar in that they are opposites. The opposite side of an account receivable is the account payable. The term that you use will depend on whether you’re buying or selling goods or services.
Both of these terms are essential to any successful brand because they keep their money organized and in order. These accounts let you know how much needs to be paid off or amounts owed—accounts payable being the liability, and accounts receivable being the asset.
How to record accounts payable
To properly record accounts payable, the total on an invoice should be credited to AP when it is received. This is offset by an expense account for the good or service that was purchased. Once the bill has been paid, the accountant debits the accounts payable, which decreases the liability balance.
Companies are allowed to have many open payments at once as long as they’re all recognized on the balance sheet. Subscriptions and installments payments also count as accounts payable.
The basic process of accounts payable is as follows:
- The company receives the goods or services.
- The account payable is recorded on the general ledger.
- The invoice is matched with a purchase order or a receipt.
- The invoice is then approved and accepted as a debt.
- The invoice gets paid in the correct amount and removed from the account.
Why are Accounts Payable and Accounts Receivable important?
Now that you understand the basics of both types of accounts, let’s talk about the importance of them in the accounting process. A lot of smaller businesses often deal with late payments that cause cash flow problems. A lot of time can be spent tracking these late payments, trying to figure out where the money is owed. This time could be used for something more important within the business, like investing in product research or marketing to new customers.
Having a steady accounts receivable and accounts payable portion of your balance sheet helps businesses maintain their cash flow and keep track of every payment that comes in and out. Companies will then be able to focus on their long-term goals rather than short-term problems.
Are Accounts Payable a business expense?
The answer is no, unfortunately. People sometimes think that accounts payable mean that this is one of the company’s core operations. However, expenses are on a company’s income statement and will look different than the accounts payable on a balance sheet.
How Accounts Payable and Accounts Receivable work together
Both AP and AR are required to complete a full transaction. For example: when Company A sells a service to Company B on credit, Company A has to record the amount to accounts receivable. At the same time, Company B has to record their purchase to accounts payable. During this time, Company A would report their sale as an asset, and Company B would report their purchase as a liability.
Once the transaction is completed, Company A has a cash increase and a decrease in accounts receivable. Company B will have a decrease in their cash and accounts payable. This is what we call symmetry in accounting.
The Bottom Line
Understanding both of these concepts is a critical part of running a business. If you run a small company that is just starting to account for AR and AP, it’s essential to identify the differences between these two accounts to improve your cash flow efficiency over time.
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