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How to Record Journal Entry of Account Payable?(Definition and Examples)

Account Payable

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.

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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.

Related article  6 Roles of Accounts Payable Manager or Department You Should Know

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:

AccountDebitCredit
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.

AccountDebitCredit
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.

AccountDebitCredit
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:

Related article  Accounting for Purchase Returns - Entry, Example, and More
AccountDebitCredit
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:

AccountDebitCredit
Accounts Payable$ XXXX 
Cash or Bank Account $ XXXX

Discount from Suppliers

Suppose the company received a discount from suppliers for early payments.

AccountDebitCredit
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.

AccountDebitCredit
Inventory/Purchases$ 50,000 
Accounts Payable $ 50,000

Example # 2

Sinra Pvt. Ltd. Returns damaged goods for $ 5,000.

AccountDebitCredit
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.

AccountDebitCredit
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.

AccountDebitCredit
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.
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