Understanding Accounts Payable
Accounts Payable is the total amount owed to a business’s vendors.
Every business has contracts with other businesses that provide them with goods or services that they do not make themselves. These businesses are called vendors.
Depending on the business relationship with vendors, they do not pay immediately but at a later date, governed by certain credit terms which allow the business to pay after a few weeks.
Let’s first understand why businesses pay with credit and not cash. Why do businesses need Accounts Payable?
Why Accounts Payable
Businesses make money by selling goods or services, but businesses need money to first produce these goods and services.
This is why businesses choose to pay vendors with credit terms rather than immediately. This allows them to pay off their vendors at a later date when the revenue from selling their goods and services starts coming in.
When businesses don’t have enough cash on hand to immediately pay their vendors, they can choose to pay their vendors at a later date, when cash is more readily available. This amount is recorded in books of accounts as Accounts Payable.
Recording Accounts Payable
Where Accounts Payable Is Recorded
Since a business is liable to pay back its vendors in the span of a few days or months at most, it is a current liability.
Businesses record their total Accounts Payable under the Current Liabilities section of the Liabilities part of the balance sheet.
Condensed Consolidated Balance Sheets
|Particulars||June ‘22||Mar ‘22|
Cash and Cash Equivalents
Property, plant, and equipment
But this is only the total amount at the end of the quarter. A business does not keep track of its accounts payable on the balance sheet.
This next section explains how a business keeps track of its Payables over the course of business.
How Accounts Payable is Recorded
The first record of AP is in the ledger: Accounts Payable is credited and the account of the good or service purchased is debited.
Read more: What is a Ledger?
Let’s say a bakery purchases flour from a vendor on credit.
This is how the flour account would look in the bakery’s ledger.
|date||transaction||amt (Rs)||date||transaction||amt (Rs)|
|25-Oct-22||To Accounts Payable||20,000|
The corresponding credit entry in the AP account would look something like this:
Accounts Payable A/C
|date||transaction||amt (Rs)||date||transaction||amt (Rs)|
|25-Oct-22||By Flour A/C||20,000|
At the end of the accounting period, the bakery will transfer the total sum of money it owes to its vendors to the balance sheet as we saw earlier.
Decoding Accounts Payable
In the balance sheet, businesses record the values of assets and liabilities for this accounting period and the last.
The payable metric is also recorded in the Cash Flow Account to understand the movement of the business’s cash. A business that is able to pay its vendors in cash and on time is a business that has good cash flow.
A high accounts payable balance means that the business has been unable to pay vendors in cash. This could be because of a number of reasons.
- Insufficient cash flow
- Initial stages of business
Accounts Payable Workflow Process
It’s very important to maintain a meticulous record of Accounts Payable. If the due amount is not paid on time, the relationship between the business and the vendor is likely to deteriorate.
Bigger companies have CAs and a finance team to manage their accounts, but smaller businesses may not have access to these facilities and may have to manage their AP manually.
As shown in the diagram above, the process is long, tedious, and error-prone.
Accounts Payable Managed
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1. What is the difference between trade payables and accounts payable?
Though the terms trade payables and accounts payable are often used interchangeably, there are slight differences in their meanings.
Accounts payable are the accrued obligations or payments which a business owes, like leasing, electricity, labour, etc. On the other hand, trade payables are the money owed to vendors for inventory like supplies, business materials, etc.
2. What is the difference between accounts receivable and accounts payable?
Accounts payable refers to the amount of money an organisation owes to its vendors. On the other hand, accounts receivable refers to the money that customers owe to a concerned company. Accounts receivable is a current short-term asset, while accounts payable is a current short-term liability.
3. Is accounts payable a debit or credit?
Accounts payable is both a debit and a credit. For double-entry bookkeeping, the accounts payable department receives an invoice which gets recorded as a credit in the general ledger and then to the expense account as an offsetting debit.
This matching principle follows the method of accrual accounting, where expenses and revenues get recorded in the same period that takes place prior to the invoice payment.
4. How is accounts payable a current liability?
For accounts payable, one receives an invoice for services or goods which are not yet paid. Hence accounts payable is a current or outstanding liability - a payment amount that a business owes to a vendor.
6. What is an accounts payable turnover ratio?
Accounts payable turnover ratio refers to a ratio which is a measure of an organisation’s short-term liquidity, namely, the average rate at which the company pays off vendors.
Essentially, this ratio is a metric that organisations use to measure the efficiency of paying a short-term debt.
A high value of the accounts payable turnover ratio implies that the time duration between receiving an invoice and making the payment is less. On the other hand, a low value of accounts payable turnover ratio indicates that the time duration between receiving an invoice and making the payment is more.
What is the difference between accounts payable and account receivable?
Accounts payable (AP) is the amount that a business owes its vendors. Accounts receivable (AR) is the amount that a business is due to receive from the businesses it supplies to.
AP is a current liability, while AR is a current asset.