What is Accounts Payable?
An accounts payable (AP) entry indicates a company's obligation to pay off debts to its suppliers or creditors within a given period in order to avoid default.
Your accounting balance sheet is replete with important lines and sub-categories. Arguably none holds as much weight as the Accounts Payable (AP) section.
This is the place where you'll keep track of all of the money you owe to the suppliers and vendors who keep your organization running.
If you're a new business owner, it's easy to become overwhelmed with these numbers and responsibilities. Yet, it's important to keep a close eye on these expenditures so you know the true state of your bottom line.
Feeling confused? We're here to help. Read on to learn everything there is to know about the accounts payable cycle and how you can master it today.
Why are Accounts Payable Important?
Payables are essentially short-term IOUs from your business to another business or entity. When recorded, the accounts payable account is credited when the bill or invoices is received, and when it is paid, accounts payable is debited.
Accounts payable entries appear under current liabilities on a balance sheet where anyone looking at the balance can see the total amount the business owes its vendors and short-term lenders.
There are distinctions with the types of debt a company has. Accounts payable are a type of short-term debt along with expenses such as business income taxes, short-term loans, and payroll costs. Long-term debts, on the other hand, include things like retirement benefits, lease payments, and other debts that are repaid over a longer timeframe. The term “trade payables” is often used interchangeably with accounts payable, but there are slight differences between the two.
- Accounts payable include all short-term debts and/or obligations.
- Trade payables represent the monies a company owes vendors for inventory-related goods.
Some accounting methods roll both of these types into the accounts payable category. Accounts payable is essentially the opposite of accounts receivable. It is the money a business owes its suppliers while accounts receivable is the money others owe the company. So, if one company lists a bill as an accounts payable, the other company categorizes that same bill under accounts receivable.
Understanding AP Trends
When reviewing your balance sheet or general ledger, do you notice that your AP section is growing over time, rather than lowering? If this is the case, it means that your company is buying more and more items or services on credit. In other words, you're opting against paying cash or taking the steps necessary to pay those debts down.
On the other hand, if you see that your AP number is lower now than it was before, it means the opposite. Rather than spending beyond your means, you're paying your creditors back at a quicker pace than you're buying from them.
Understanding where you're at in this pendulum is critical to properly managing your company's cash flow.
Relationship Between Cash Flow and AP
Many accountants use the indirect method to prepare their cash flow statement. If this applies to you, your AP updates will appear in the top section of your balance sheet, titled Cash Flow From Operating Activities. Here, you can find your net AP increase or decrease since the last time you tracked those numbers during the prior period.
It's always a best practice to pay your supplier bills on time as soon as they come in. Still, it's not uncommon for business managers to view their AP data and manipulate their cash flow accordingly to achieve specific aims.
Consider, for instance, that your company is about to ramp up a major new project and you need your cash reserves to be as healthy as possible. In this case, management could withhold from paying its outstanding AP accounts, allocating those funds to the project instead. While this might be an effective approach in the short-term, keep in mind that it could have devastating, long-term effects.
Consider the implications that a failure to pay could have on your vendor relationships and your overall business reputation. Rather than giving in to this approach, it's wise to stick to a regimented and on-time payment schedule.
How to Record Your Accounts Payable
If you're adhering to the proper, double-entry bookkeeping style, you'll always need to enter an offsetting debit every time you enter a credit into your general ledger, and vice versa.
That said, how do you update your AP section?
This part is relatively straightforward. Every time your business receives a bill or invoice, you'll credit your accounts payable, increasing the overall amount that your company owes. However, you're not finished quite yet.
Then, you'll need to add a debit to offset that credit and keep your balance sheet balanced! In most cases, you'll debit an expense account that's assigned to the good or service you just purchased on credit.
When you pay your bill, you'll add that debit to your AP section. This lowers your overall liability balance and ensures your records reflect the most current numbers. To achieve balance, you'll enter an offsetting credit to your cash account (and lower your cash balance) for the same amount.
Putting It Into Practice
Need a real-life example of how AP works on a general level? Let's dive in.
Imagine your business receives an invoice for $1,000 worth of new printer hardware. As soon as your AP department receives that invoice, they will enter $1,000 as an AP credit. Then, they'll add a corresponding debit entry in your special "Office Supplies Expense" category for $1,000.
Note that even if you haven't paid out the actual cash required to cover this purchase, it will still show up in your expense category. Most industry professionals who follow the accrual accounting method will perform this step of recording the transaction as soon as the purchase is finalized and the expense is incurred, rather than when the cash is paid out.
When the $1,000 bill comes, your company pays it. Now, you can credit your cash account and debit your AP accordingly.
Your Accounting Issues, Solved
Small business owners are some of the busiest and most overwhelmed professionals on the planet. Unless you're well-versed in accounting, it can be difficult to grasp the nuances of the process.
This is especially the case with Accounts Payable. A major part of your balance sheet, this section alone can help keep your bottom line comfortable and improve your supplier relationships. Knowings its major sections and how it works can help you set your company up for long-term success.
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