Top 5 Reasons Why Account Payable is Understated

Accounts Payable

Accounts payable form the largest portion of the current liability section on the company’s financial statements. It represents the purchases that are unpaid by the enterprise.

In the cash conversion cycle, companies match the payment dates with accounts receivables making sure that receipts are made before making the payments to the suppliers.

Lower the accounts payable days the better. It reflects that the company is able to realize the cash in good fashion.

Process flow of accounts payable

The following is the paper trail in the cycle of accounts payable:

1. The buyer asks for a quotation from suppliers along with payment terms and conditions.
2. The buyer makes the purchases from suppliers on the account.
3. The buyer receives the inventory/purchases.
4. The buyer checks the purchases made for the quality he ordered and decides whether to accept the order in partial and full.
5. The buyer makes purchases return for purchases which are found to be defective.
6. The buyer makes the payment in full.
7. Any outstanding liability is carried forward to next year.

Reasons for understatement of accounts payable:

Accounts payable understatement is due to inaccurate reporting of balances or invoices or other miscellaneous reasons which will reflect in the discrepancy in the financial statements.

There are various data errors that render accounts payable to understated. These can be corrected by determining the cause of understatement.

1) Inventory variances – understating inventory

Incorrect recording of inventory purchases is one of the most common reasons for the understatement of accounts payable. When purchases are made on account from suppliers, accounts payable are created.

When the inventory balances are recorded and the balances are recorded by understating it the resultant accounts payable balances would also be understated.

Going further, the discrepancies may occur when the accountants record the inventory financial events without giving the due care on inventory policies and valuations.

2) Incorrect transaction dates

Let’s take the example that purchases were made on account as on the 1^st of December,2019 and received on 12^th Jan, next year.

The accountant shall correctly record the purchases on 1^st Dec 2019. However, due to confusion surrounding the dates, he records on 12^th Jan 2020. This will overstate the accounts payable balance for the year 2020.

This will overstate the accounts payable balance for Jan month and understate the balance for the December month. Therefore for the month of December, the accounts payable balances would be understated.

3) Incorrect invoices

Let’s take an example. Mr. Ram made purchases of $ 50,000 from Mr. Shyam. The inventory was received as usual and accounted for. Mr. Shyam erroneously sent the invoices for $ 5,000.

In the books of Mr. Ram, the accountant made the error of recording the invoice and understated the accounts payable balance by  $45,000. This may have verified through robust internal control but the accountant did not do so and resulted in the discrepancy in the record in the books of Mr. Ram.

Such discrepancy can only be removed and corrected through cross-checking of accounts and balances.

4) Wrong opening balances

If the accountant has already understated the accounts payable balances in the last accounting period, the same balances will be understated in the current accounting period. This can be rectified through a good internal control system.

5) Incorrect entry posting

The chances of errors of commission and omission are high that would reflect in the financial statements. The accountant erroneously records the purchase returns account to Mr. Dave instead of Mr. David to whom goods have been returned.

In this case, the overall accounts payable balances would be the same however, the individual balances would be distorted. The accounts payable balance of Mr. Dave would be understated and that of Mr. David would be overstated in this scenario.