No business entity operates without having credit purchases and credit sales. Credit purchases and credit sales give rise to account payables and account receivables. Both accounts are recorded on the balance sheet of the business entity and are integral to the business operations.
Account receivables(AR) and account payables(AP) are significant for internal accounting and external stakeholders. Both accounts play an important role in determining the short-term liquidity position of your business entity. The creditors look at the account payables and account payable turnovers to assess the payback ability of the business entity.
Account payables and account receivables are core accounts for tracking the collectibles and payables in the accrual-based accounting system. Many small businesses face a hard time due to failure in managing the account receivables and account payables.
The recording and handling of AP and AR are similar, and business owners get confused when handling both simultaneously. Therefore, it is important to understand the difference between the two for managing the bookkeeping and accounting process.
What Are Account Payables?
Account payable is a liability of a company that the business entity owes to creditors and third parties. Generally, short-term payables like credit purchases are recorded under the account payables.
We can define account payable as,
Account payable is a general ledger account of a business entity that reflects its short-term debt to its suppliers and creditors. When a business entity makes a credit purchase, the account payable in the creditor’s name is created. The item is shifted to the current liabilities in the balance sheet.
The account payable of a business entity is its liability and is recorded in the balance sheet. The first point of entry in the accounts of the book for the accounts payable is the general ledger.
After the bookkeeping, the AP is recorded as a current liability on the liability side of the balance sheet. The current liabilities are payable within 12 months.
An account payable ledger is created by aggregating all the due payments to the business entity’s creditors and suppliers, and a consolidated amount is recorded.
Explaining Account Payable
Account payables play a significant role in the business entity’s cash flow and management. The AP is future cash outflows due within 12 months from recording. The increase in AP means a higher cash outflow in the future, and a lower AP balance means less cash outflow.
In the indirect method of cash flow statements, the decrease in AP is added to net income, and the increase is deducted from the income.
If we talk about recording accounts payable in the books of accounts, they’re a balance sheet item. However, the creation of accounts payable corresponds to a transaction of a business entity.
The accounts payable, the short-term debt of a business, are recorded under the double-entry system that requires an equal amount of debit and credit in every transaction.
What Gives Rise To Account Payables?
The account payables arise due to credit purchases or outstanding payments toward external parties. For instance, a retail store owner purchases the inventory on credit, and it will be payable within 12 months from purchase.
Acquiring the inventory shows an increase in the business’s assets, whereas it gives rise to an equal amount of liability as due payment under account payables.
The double-entry accounting system will record the transaction with inventory as a debit and account payable as a credit.
Suppose the supplier offers any trade discount. In that case, it will also be credited, and the remaining amount will be credited to account payables.
Similarly, the bills payable are recorded to pay any due amount to external parties: banks, individuals, businesses, etc. Bill payable is also a part of accounts payable due to any outstanding payment to external parties. However, some business entities record short-term loans as separate items in the balance sheet.
A bill payable is usually derived from the accounts payable as it is a formal proof that company ABC owes XXX USD to company XYZ. The creditor can discount the bill payable by presenting it at the bank. In that case, the bank becomes a creditor of the company ABC instead of company XYZ.
Settling The Account Payables
When the due date arrives, the company pays the creditor with cash or cheque. It will decrease the cash or bank balance of the company. Since both are company assets, the decrease in the asset will be credited for either case.
On the other hand, offsetting the account payable will show a decrease in the company’s liabilities, which is a debit. The journal entry will be account payable debit and cash or bank credit. Any cash discount for early payment will also be credited, and the remaining amount will be credited from cash.
Let’s take an example.
Fredrick & Co. had purchased inventory from Peter & Co.(supplier) on credit amounting to $1,000. The amount was due in 3 months. The journal entry for the credit purchase was as follows:
|Peter & Co. Account/Account Payable||$1,000|
After three months, the cash was paid to Peter & Co. in settlement of his account. The books of account recorded the transaction as a journal entry,
|Peter & Co. Account/Account Payable||$1000|
What Are Account Receivables?
Account receivables are recorded in the business’s financial statement as a short-term asset that arises due to inward cash flow probable in the future.
Account receivable can be defined as,
An account receivable account is a general ledger account that is created when the business entity makes credit sales or issues a short-term loan to its debtors. The AP is recorded in the financial statements as a part of the company’s balance sheet. It is recorded on the asset side as a current asset.
The company’s account receivables are the balance sheet item and are treated as current assets. Current assets are the short-term assets that are collectible within the 12 months from the recording.
AP represents the cash receivables, and therefore, they contribute to the company’s future cash flows. However, the current impact of the AP in the indirect cash flow statement is adjusted by subtracting the AP’s increase and adding the AP’s decrease into the net income.
Explaining The Account Receivables
Besides being an important account in cash management, AR plays an important role in the working capital requirements of the business entity. The working capital of a business entity represents the difference between the current assets and current liabilities.
AR is part of the short-term liabilities. Therefore, it plays a positive role in working capital. However, too much AR might be a bad signal showing a business entity’s inability to recover its receivables.
At the same time, the account receivable also represents the company’s credit sales showing revenues for the business entity.
What Gives Rise To Account Receivables?
When a business entity makes credit sales, the debtor account arises. The inventory(asset) decreases, whereas another asset as the debtor is created in the accounts.
According to the double-entry system, the inventory account is credited. The debtor account is debited in the books of accounts.
Bills receivables are a form of account receivables signed between the business entity and the debtor. The debtor’s promise to the business is to pay a sum of debt on the specified date and terms. When a bill receivable is signed, the account receivable account decreases and increases.
Offsetting The Account Receivables
When the due date arrives, the debtor pays the due amount or honors the bill. Another possibility is that the debtor fails to pay the due amount resulting in bad debts for the business entity, which is an expense.
When the debtor pays the due amount, cash is debited, and the account receivable is credited with the amount paid.
Let’s take an example.
Fredrick & Co. had purchased inventory from Peter & Co.(supplier) on credit amounting to $1000. The amount was due in 3 months.
The journal entry for the credit sale will be recorded in the books of Peter & Co. as follow:
|Fredrick & Co. Account||$1000|
After three months, the cash was received by Peter & Co. The books of account recorded the transaction as a journal entry,
|Fredrick & Co. Account||$1000|
Difference Between Account Receivables And Account Payables
Account Receivables and Account Payables are two sides of the same coin. However, there are the following major differences between the two:
What Is It?
Account payable is due on the business entity for the outstanding amounts yet to be settled—the account payable results when credit purchases are made.
Account receivable is cash receivable by the business entity from the debtors in the future—the account receivable results when credit sales are made.
Balance Sheet Position
AP is shown on the liability side of the balance sheet as a current liability. AR is shown on the asset side of the balance sheet as a current asset.
Accounts payable can’t be offset and can only be settled by paying the due amount. However, the provision for doubtful debts is generally created by business entities to offset the part of account receivables that is irrecoverable.
In the case of the account payable, the business entity recording the AP is liable to pay the amount. The business entity recording AP is a debtor to another individual or company.
For accounts receivables, the debtors of the business entity recording the AR are liable to pay the money.
Impact On Cash Flow
The account payables, when settled, result in cash outflow. On the other hand, account receivable collection results in cash inflow for the business entity.
In a Nutshell,
Account receivables and account payables have several differences, and they vary. However, both accounts are crucial in a business entity’s working capital and cash management. Therefore, managing them by understanding the key differences is necessary.