Overview
Accounts Payable (AP) refers to the short-term debt obligations of a business. It is one type of trade credit that businesses use to manage their cash flows.
Managing accounts payable effectively can boost a business’s credit. It can help reduce reliance on expensive bank loans. However, it should be handled carefully to manage the supplier relationships.
Let us discuss accounts payable, what’s included in it, and how to record the journal entries.
What is Accounts Payable?
Accounts payable is the money a business owes to its vendors and suppliers for the supply of goods or services. It is the short-term debt obligation of a business towards its creditors.
Accounts payable become due for the short-term that is within one year. Accounts payable is a liability account. Unlike a common notion, AP is not an expense account.
A company’s all accounts payable accumulated show under the current liability section of the balance sheet. AP account represents the company’s short-term payable obligations to its creditors and suppliers.
Managers can use AP figures to analyze the company’s credit terms. An increase in accounts payable means the company is making more purchases on credit. Contrarily, an increase would mean purchasing on cash terms or with a short account payable cycle.
The management can adjust accounts payable terms to manage short-term cash flows. However, the terms must not compromise the trade relationships between the company and its suppliers.
What is Included in Accounts Payable?
Generally, any short-term business obligations can be categorized under the accounts payable account. The AP account represents what a business owes in short term or within one year.
The most common item is included in the balance of outstanding invoices of a company. It means the sum of purchases made on credit by the company.
A business may make large supplier contracts with its suppliers and vendors. These contracts include an upfront payment and subsequent payments in installments. Short-term liabilities for these contracts that become due within one year are recorded under the accounts payable section.
Accounts payable can combine the obligation for the purchase of goods or services received. However, services related to the direct business operations will be recorded in the accounts payable section and others in the trades payable sub-section.
How Does Accounts Payable Work?
Depending on the size and complexity of the business, accounts payable can have single or multiple sections. The process includes recording invoices, credit terms, payments, returns, and so on.
Step # 1: Receiving Invoice
The first step is to receive invoices from suppliers. The invoices can include purchases for inventory, office supplies, services received, and so on.
The accounts payable will show an accumulated balance of all short-term invoice balances.
Step # 2: Invoice Processing
The next step is to process the invoices internally. The management will assign accounts payable to its sub-sections and plan for the payment terms.
Step # 3: Verifying Bill Details
During steps 2 and 3, the company will verify bill details including rates, credit terms, dates, vendor details, and so on.
These steps will also include verifying outstanding invoice balances for each vendor.
Step # 4: Making a Payment
Once the bills are verified, the company can decide to make payments to one or several vendors. At this stage, the company will dispatch payment cheques or transfer funds to the suppliers.
This step includes confirmation of payment from the suppliers as well.
Step # 5: Reconciliation
The final step is the reconciliation of the accounts payable account. The step will include reconciliation of outstanding dues and payments processed. Any discrepancies will be accounted for and corrections will be made accordingly.
How to Record Accounts Payable?
When a business makes a transaction of goods or services purchased on credit, there will be a resulting accounting entry to accounts payable.
There are six commonly used types of journal entries to record accounts payable with different transaction types.
Inventory Purchases
This is the most common form of journal entry for accounts payable. Whenever a business purchases inventory, raw material, or other supplies on credit, a transaction can be recorded for the AP account.
The Journal entry to record such transaction will be:
| Account | Debit | Credit |
| Inventory/Purchases | $ XXXX | |
| Accounts Payable | $ XXXX |
Returned Goods
In case a business received damaged goods, it can return and record such entries against accounts payable as well. The company will create a new allowance for returned goods account to record such transactions.
| Account | Debit | Credit |
| Accounts Payable | $ XXXX | |
| Allowance for Returned/damaged goods | $ XXXX |
Assets Purchased
A business can purchase assets with a short-term credit as well. Such transactions will also be recorded under the current liabilities and AP account section.
| Account | Debit | Credit |
| Relevant Asset Purchased | $ XXXX | |
| Accounts Payable | $ XXXX |
Recording Entry for Services Received
A business can receive services such as legal, financial, or consultancy services on credit as well.
The journal entry to record such credit transactions will be:
| Account | Debit | Credit |
| Expense Accounts (for services) | $ XXXX | |
| Accounts Payable | $ XXXX |
Making a Payment
When the business makes a payment for credit accounts, it will reduce the accounts payable liability.
The journal entry will be:
| Account | Debit | Credit |
| Accounts Payable | $ XXXX | |
| Cash or Bank Account | $ XXXX |
Discount from Suppliers
Suppose the company received a discount from suppliers for early payments.
| Account | Debit | Credit |
| Accounts Payable | $ XXXX | |
| Discount Received | $ XXXX | |
| Cash or Bank Account | $ XXXX |
Working Examples
Suppose a company Sinra Pvt. Ltd. Produces fashion clothes. It purchases raw material and inventory supplies from different suppliers on credit terms.
Let us consider some scenarios discussed above with figures.
Example # 1
Sinra Pvt. Ltd. Purchases raw material worth $ 50,000 on a one-year credit term.
| Account | Debit | Credit |
| Inventory/Purchases | $ 50,000 | |
| Accounts Payable | $ 50,000 |
Example # 2
Sinra Pvt. Ltd. Returns damaged goods for $ 5,000.
| Account | Debit | Credit |
| Accounts Payable | $ 5,000 | |
| Allowance for Returns | $ 5,000 |
Example # 3
Suppose during peak production time, Sinra Pvt. Ltd. Decides to buy new machinery to improve its production facility. The Machinery costs $ 25,000 and the credit term is within one year.
| Account | Debit | Credit |
| Tools and Equipment | $ 25,000 | |
| Accounts Payable | $ 25,000 |
Example # 4
Suppose Sinra Pvt. Ltd makes a payment of $ 30,000 to its suppliers to reduce the payable liability.
| Account | Debit | Credit |
| Accounts Payable | $ 30,000 | |
| Bank Account | $ 30,000 |
Accounts Payable vs Trades Payable
Both terms are often used interchangeably. However, trades payable refers to the obligations for purchases made for direct trade costs such as inventory and raw material.
On the other hand, accounts payable can include operating, financial, and other short-term liabilities of a business. Thus, accounts payable includes a comprehensive set of short-term debts of a company.
Managing Accounts Payable
Effective management of accounts payable is an important part of working capital management. It can help a business increase cash flow and reduce reliance on expensive bank loans.
Here are a few quick tips for you to manage accounts payable efficiently.
- Choose preferred suppliers and vendors that offer quality supplies.
- Negotiate credit terms with suppliers and vendors.
- Create long-term partnerships with trustworthy suppliers.
- Make early large payments to reduce accounts payable liabilities.
- Make scheduled payments to keep AP balance under control.
- Centralize the accounts’ payable function and automate the process through digitization.