Often a company will purchase goods and/or materials from a supplier or vendor and in the process of doing so, they will frequently use their credit with that supplier to make the purchase. For the company purchasing the goods, this transaction will then be entered into the ledger as an Account Payable. As the company responsible for paying the money back, this then becomes a liability until the amount is paid in full. Within a business, there is often an Accounts Payable department that is tasked with taking care of all such debts owed to creditors. For the business providing the goods and extending the credit, this transaction will be reflected on their balance sheet as an Account Receivable.
Accounts Payable (AP/): A Few Basics
On a company's balance sheet, under current liabilities, will be a list of all accounts payable. These are debts owed that have to be paid off within an allotted amount of time. If these debts are late or are not paid, for whatever reason, then the company will be in default on that particular AP. When two businesses have a working relationship, it is not uncommon for one of the companies to extend the other credit to this end—think of it as a type of IOU. The terms for repayment on this are usually fairly short—generally a few weeks at most. As noted, the company that offered the credit, in this case, would record the transaction on their end as an account receivable.
Keeping tabs on AP is incredibly important. Patterns may emerge that suggest a business is buying more and more on credit without paying down the balances; this means of course that they are not paying cash, perhaps because they are unable to do so. Which in turn could suggest a problem with the company's overall cash flow situation? On the flip side, if AP decreases, then obviously the business has been able to pay off debts owed faster than it happens to be buying new items on credit. Understanding where a business stands in this respect is important especially when it comes to managing cash flow.
For example, if cash flow happens to be tight the company can potentially use its AP to a certain extent. That is to say, if they take longer to pay on the accounts, they reserve some of that cash and at least for the short term have extra funds available. Keep in mind, such a strategy could affect a company's relationship with a specific creditor. If the creditor in question is depending on that account receivable this very well might present a bit of a tricky situation. Paying bills on time by the due date is always the best practice, particularly when it comes to maintaining strong B2B relationships.
Bookkeeping and AP
In keeping track of accounts payable, a double-entry system will be used for bookkeeping purposes. So for instance, in recording an account payable, the AP department or accountant will credit accounts payable and they will offset this by debiting somewhere else—as every credit entered requires a corresponding debit. And then when that AP is paid in full, the accounts payable is debited (decreasing the liability/) and the credit is now given to a cash account.
Using real numbers…Let's say a company accrues a debt of 2000.00 for tech-related items. Upon receiving the invoice, the AP department will credit accounts payable the 2000.00 and enter it as a debit under tech equipment. This 2000.00 expense will still show on the income statement as an expense despite not yet being paid. This is pretty standard practice—an expense is considered an expense at the time of purchase rather than at the time of actual payment. Once that bill is finally paid, the AP department will then enter the 2000.00 as a debit under AP and a credit on the cash account.
Companies will frequently have multiple outstanding payments to suppliers. And all such debts will be list on the balance sheet as an account payable. This will then show the total amount owed to creditors at any given time. So, if in conjunction with the 2000.00 for tech equipment a company also has an outstanding bill for office supplies for 300.00, the total amount listed under accounts payable would be 2300.00.
What is Trade Payable?
Some people are apt to use the phrase trade payable interchangeably with accounts payable. There is however a difference. Trade payables are more specifically is linked to money owed for goods and products related to inventory. Accounts payable is more of an umbrella term here, denoting all outstanding shorter-term debts owed. Looking at the example of a salon/spa…if they owe for beauty products or styling accessories, these would fall under the trade payables category as they are directly related to inventory. On the other hand, if they have outstanding debts for lawn maintenance let's say, or facility cleaning then these would be applied to accounts payable. And consequently, all such debts would fall under the umbrella of accounts payable.
What are Accounts Receivable?
An account receivable is the opposite of an account payable. As mentioned, the supplier who is extending the credit to a company will list this in their ledger as an account receivable. On a company's balance sheet this will appear as an asset. Generally, the account receivable is collected within a few weeks and is thus in some ways much like a short term loan.
Under the current asset section of the balance sheet is where you will find accounts receivable. These are considered assets because they represent future value for a business. Now, if for some reason a client fails to pay, then this would be considered a bad debt. Many businesses will establish an "allowance for uncollectible accounts." Unfortunately, most companies will at some point or another come across that client that habitually pays late or not at all. To prevent painting an unrealistically high picture of accounts receivable, they, therefore, relegate a certain percentage of their accounts receivable—anywhere from 5-10% for example—to this allowance of uncollectible accounts.
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