This comprehensive article will cover what is accounts payable as a whole, including its role in accrual accounting systems, how to create accounts payable and to facilitate a good audit trail, and will also explore the pros and cons of having a cash vs accrual-based accounting system.
What is accounts payable?
Accounts payable refers to a comprehensive list and recording of a business’ or company’s liability and debt owed due to the purchase of goods and services. Taking delivery of ordered products without paying for them, purchasing goods on credit, is recorded as accounts payable. An accounts payable refers to the liability owed to a creditor for goods and services purchased on credit or on account. An Accounts Payable is also referred to, in accounting terms, as a Trade Payables. Accounts payable lists out an organization’s short-term debts and current liabilities. Long-term debts and liabilities like leases and staff payroll are not considered accounts payable.
Accounts Payable is a liability account, having a credit balance to operate with. During double entry accounting for a business’ account, any invoice received from creditors it is credited to Accounts Payable. When recorded accurately, the total credit balance must be equal to the sum total of the outstanding vendor invoices received. The accounts payable balance must be equal to the sum of unpaid vendor invoices.
Use of accounts payable in accrual accounting systems
The use of accounts payable and trade payables is obtainable only in businesses or companies that operate an accrual-based accounting system rather than a cash-based system. An accrual-based system account for all business transactions carried out over a specified period of time regardless of when actual cash flow is recorded in and out of a business’s account.
Accounts payable for individuals and households refers to accrued documentation of bills for domestic services and utilities. Household accounts payable must be played within a specified time period to prevent discontinuation of utilities and such essential services. Universities also employ the use of accounts payable when dealing with vendors or independent contractors that supply the departments in the organization goods and services.
A company may also have a dedicated department or employees to streamline the audit trail needed in maintaining a general ledger for the business. The accounts payable or AP department deals with invoices and bills from suppliers and vendors. The AP department keeps track of the crediting and debiting of the liability account, with regards to accounts payable.
How to create accounts payable
Accounts payable are listed in a company’s general ledger under the current liabilities section. The finance department credits accounts payable when the company receives an invoice or a payable from a creditor and debits accounts payable when the bill owed the creditor is paid.
An accurate audit trail is required to properly keep an accounts payable ledger. An audit trail is a comprehensive recording of all activities regarding a specific transaction. A purchase of goods and services must be recorded- its invoice properly recorded as received and payment of such bills must be accounted for.
An accounts payable contains the following important data:
- Vendor/Biller’s Name: The name of the organization you owe for their supply of goods and services.
- Account Number: Your business’s account number for billing
- Invoice Number: Record the invoice number to enable you cross check the figures recorded with the hard copy and ensure accurate accounting.
- Expense Type: Specify the nature of the goods and services purchased.
- Invoice Receipt Date: Record the date you received the vendor’s invoice. The date to be recorded is when you took delivery of the invoice rather than the date on the invoice.
- Payment Deadline: This is when the invoice is due for payment. Ensure you track the parent deadline to prevent incurring charges and fees that result from late payment of invoices.
- Status: Has the invoice been paid, past its delivery date or still pending.
An audit trail allows an organization keep track of the status of accounts payable. Upon receipt of a vendor’s invoice, the accounts payable is credited and payment of the same voice leads to accounts payable being debited.
The following documents are tracked and recorded under accounts payable:
- Purchase Orders
- Suppliers and Vendors Invoices
- Agreements with Vendors and Independent Contractors
Universities that employ vendors or retain the services of independent contractors must obtain a W-9 form, available on the IRS website, in order to properly file accounts payable. The W-9 form is used for discovery of relevant information about the vendor or contractor. The university’s treasury deals with the release of financial statements, account payables for services rendered by vendors and independent contractors. Vendor invoices sent to the university for services like providing office supplies, setting up payment services for students and other student services are all credited to accounts payable.
Accounts payable do not include expenses incurred over legal documents or instruments entered into by the business. The items recorded under accounts payable are of a temporary and short term nature. Expenses that are of a long-term nature employee payroll, rents, and leases are not recorded under accounts payable.
The opposite of accounts payables – accounts receivables
The opposite of account payables are account receivables– outstanding debts owed a business by its clients. Account receivables and account payables are balanced in order to determine the company’s financial status. A profitable company, when balancing its general ledger, both liability account and assets account, will normally have account receivables as a larger number, compared to account payables.
A cash-based account system or accrual-based accounting: pros and cons
Proper ledger keeping in a business leads to a better, efficiently run, financially secure establishment. When establishing a business you must decide on what accounting system to implement in tracking your finances. Company accountants or at times independent contractors can maintain the business’s general ledger. The two accounting systems that are mostly used and recognized by the Internal Revenue Service are:
- Cash basis accounting system
This is a money based accounting system that emphasizes cash flow. The transactions recorded in the business’s ledgers are only those that involve instant cash remittal. Invoices, bills and purchase orders are not recorded under expenses or revenue. Accounts payable are not listed in the company’s ledgers as only the actual cash flow in the period under review is recorded.
Cash based accounting system is usually utilized by small-scale businesses that deal with instant cash dealings. The major benefit of running a cash based system is the fact that the business’s actual cash flow and current actual financial capabilities can be measured, a contrast from an accrual based system where unpaid invoices and bills are recorded in the company’s ledgers. Cash based account system is utilized because of the simple nature it entails, accountants keep a single entry ledger system. There are only two entries the accountant has to keep track of
- Cash Inflow- the money the company earns, recorded upon receipt of money.
- Cash Outflow- this contains all cash transactions the company carries out.
Instruments like promissory notes, invoices and billable expenses are not recorded under a cash based account system. Terms like accounts payable, trades payable and accounts receivable are all not accounted for in the expense account or revenue account of the business. Only transactions with actual cash flow are recorded over the period of time in review. A business seeking to expand its portfolio cannot feasibly run a cash based system successfully because credit is an essential part of all successful businesses.
- Accrual-based account system
An accrual based system tracks revenue and expenses, recording details of both at the time they are incurred not at time of cash flow. Transactions are recorded as either revenues or expenses at the time they are formally agreed upon rather than the day the actual cash is paid or received. Accrual based accounting is employed by medium to large scale organizations, a contrast from the cash based system that is used by retailers and small businesses.
Accrual based accounting has the advantage of painting a clear financial picture of the company in review. With consideration for billing and invoice deadlines, a company can accurately predict its financial status at he end of a financial period. Accounts payable and accounts receivable are mainstays in an accrual based system. Accounts payable is the money owed to creditors while accounts receivable is the money owed the company by debtors.
Although accrual based system of accounting is regarded as the most effective method of accounting, it has the drawback of not giving an accurate depiction of actual business cash flow. The use of account payables and account receivables may lead to financial difficulties if both accounts are not properly kept. The importance of an audit trail is emphasized when operating an accrual based system.
Importance of accounts payable
Tracking the accounts payable of a business is essential in order to keep the finances of the business well accounted and prevent a bookkeeping nightmare. Accounts payable usually have a deadline, failure to keep to the same would lead to negative consequences.
A company’s accounts payable should be well tracked and paid for the following reasons:
- Avoiding Late Payment Fees and Fines Due To Breach of Payment Terms
- Ensuring Continued Business Relationship with Creditors
- Improving Credit Score
- Preventing Financial Fraud
- Preventing Overpayment