Finance teams everywhere are responsible for accounts payable, and a large part of their role is to pay debts off on time, every time. For many medium and large organizations, purchasing and receiving goods and services doesn’t happen on the same day as paying the vendor or contractor.
But what exactly is accounts payable? And why is it so important to an organization?
In this blog, we outline everything you need to know about accounts payable.
What is accounts payable?
Accounts payable refers to the list of an organization’s liability or debt, which is owed due to the purchase of goods and services. Accounts payable is also referred to as trade payables.
Quite simply, accounts payable lists out an organization’s short-term debts and current liabilities. Long-term debts and liabilities (like leases and staff payroll) do not qualify as accounts payable.
As a liability in the general ledger, accounts payable has a credit line that matches the balance owed. Similar to how credit cards work, the cardholder spends the credit card company’s money on the agreement that the money will be paid back in full. Therefore, at the end of the ledger, the total liabilities in amounts owed should equal the total amount of credit. The accounts must balance and the balance sheets should show a difference of zero.
Accounts payable and accrual accounting
Accounts payable works best in accrual-based accounting systems rather than on a strict cash basis. As stated earlier, many medium and large businesses trade on a level where there’s a constant flow of goods, services, and payments, and the three don’t always match up at the same time.
The best example of AP outside of accrual-accounting systems is any modern household. You pay basic costs like rent (or property taxes), and utilities like water and energy. Whatever the total amount owed for the utilities a household enjoyed last month is the accounts payable for the household. In these cash-based systems, failing to reconcile your AP for the last billing period has dire consequences. In accrual accounting, the organization making the purchases will have a different arrangement and a different schedule for billing.
Many organizations have teams of accountants working day in and day out to maintain and resolve the balances from accounts payable. But for many others, they turn to automated solutions to manage AP processes.
The accounts payable essentials
For every organization, a successful AP process requires the same information. Here are the essentials for any accounts payable balance sheet:
1. Vendor name
Organizations need to know which person or company they owe money.
2. Account number
This is usually the organization’s billing account, while other accounts have other specific purposes.
3. Invoice number
This is the most important information on the invoice other than the vendor name and billing amount.
4. Expense type
Was it a technology expense? An office-supply expense? A miscellaneous expense?
5. Invoice receipt date
This is the actual date the organization received goods or service, not whenever the vendor drafted the billing statement.
6. Payment deadline
This is the last day to pay before problems occur.
This is whether or not the accounting or procurement team has paid the invoice, or whether it’s pending, late, or in review.
The opposite of accounts payables: accounts receivables
The opposite of account payables is account receivables. This is outstanding debts owed to an organization by its clients. A profitable company, when balancing its general ledger (which contains both the liability account and assets account) will normally have account receivables as a larger number, compared to account payables.
Trades payable is money owed to vendors for everyday inventory goods. The more general term “accounts payable” represents all short-term outstanding debts, including trade payables.
These other accounts payable liabilities often include instalment payments for business loans, tax revenues owed to governments, and payments on company credit cards.
A few AP tips for non-accountants
A lot of smaller organizations are experiencing wonderful growth, but they’re still not at that stage where hiring a team of expert accountants is even an option yet.
Here are two simple ways that the owners or managers of these growing underdogs can create an accounts payable record.
First, every invoice, billing statement, and every other item in the accounts payable record should conform to a standard format and include all of the accounts payable essentials listed above.
And secondly, file accounts payable under “liabilities” in the organization’s general ledger. To make accounts payable easier to maintain, resolve, and balance, AP tracks the following types of documents: purchase orders, invoices from vendors and suppliers, contracts and payment terms, and any other agreements with vendors and independent contractors.
The pros and cons of accounting systems
Proper ledger keeping in an organization leads to a more efficient and financially-secure organization. And when establishing an organization, you must decide on what accounting system to implement in tracking your finances.
Here’s a run down of cash-based accounting systems and accrual-based accounting systems.
Cash-based accounting system
This accounting system emphasizes cash flow. The transactions recorded in the organization’s ledgers are only those that involve instant cash remittal. Invoices, bills, and purchase orders are not recorded under expenses or revenue, and accounts payable is not listed in the organization’s ledgers. Instead, you only record the actual cash flow in the period under review.
A cash-based accounting system is usually used by small-scale businesses that deal with instant cash dealings.
The major benefit of running a cash-based system is the fact that it becomes easier to measure an organization’s actual cash flow and current actual financial capabilities. They’re also a lot simpler in nature and there are only two entries the accountant has to keep track of, including:
- Cash inflow: The money the organization earns, recorded upon receipt of money.
- Cash outflow: This contains all cash transactions the organization carries out.
It’s important to note that things like promissory notes, invoices, and billable expenses are not recorded under a cash-based account system.
Accrual-based accounting 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. In short, accountants agree on transactions and then record them, rather than recording them after making a payment.
Accrual-based accounting has the advantage of painting a clear financial picture of the organization in review. With consideration for billing and invoice deadlines, organizations can accurately predict its financial status at the end of a financial period.
In accrual-based accounting systems, accounts payable and accounts receivable are mainstays. Although accrual accounting is the most effective method of accounting, it has a drawback: it doesn’t give an accurate depiction of actual cash flow. If you fail to maintain both the AP and AR books, it can lead to financial difficulties.
This is why an audit trail is essential for organizations using an accrual-based accounting system.
Accounts payable: the key to healthy finances
So, why are accounts payable important? It’s simple really. Firstly, it’s important to track the money your organization owes to vendors and independent contractors. To make money, you have to spend money, but what matters most is how you manage it. Organization’s require goods and services to operate, and those things cost money.
Secondly, responsible tracking of accounts payable ensures that organizations avoid late fines and don’t negatively impact their credit score.
Oh, and it goes without saying that responsible accounting prevents overpayment, fraud, and ensures compliance and credibility, all of which are imperative to what matters most: successful growth.
Editor's note Original publish date: 16 July 2016 We've since updated and republished this blog post with new content.