When a business does an ordinary course of operations, it must purchase its primary inventory from external vendors to survive. When the inventory is delivered to the company, vendors send an invoice to the purchasing party to pay for the proceeds of the inventory.
When its relevant department receives the invoice, they must record trade payables or the proceeds payable to the vendor.
These trade payables may be payable in any course of a short time. Trade payables are a short-term liability of the company and are placed under the current liabilities of the balance sheet of the company.
If the trade payable is not recognized in the entity’s financial statements, the entity should at least accrued the expenses the same as the trade payable that the entity will have to records.
Trade payable and account payable is used interchangeably.
Terms of payment:
When supplying the goods or services to the purchasing company, vendors will agree with them about certain terms and conditions before the supply of goods or services. This is how the market is working.
Different industries will have different terms for the period of payments. This period, however, depends on the level of competition among the vendors of the industry. Highly competitive industries will have flexible periods of payment along with providing discounts to purchasing parties.
This may range from 60 to 90 days. On the other side, low, competitive industries can agree on demanded periods and prices.
Purpose of Trade payables:
An efficient company may have small to specific large balances of trade payables. When a company does operations, they will need money for their daily operations such as purchasing inventory, paying salaries to employees, everyday usual expenses, etc.
In this case, the company may want to lend money from the bank for these purposes. However, bank loans to the company are secured against some securities and large payments of interest every period. This creates a risk for the company of default.
On the other hand, the company may want to increase its liquidity by purchasing large quantities of inventories through credit from its vendors.
These payments or trade payables after the agreed period are free of interest in most cases. This is free money provided to the company by its vendor.
The risk created by trade payables:
A company may need more cash for its operations compared to its current cash reserves and trade payables. When a company highly increases the trade payables balance, this decreases the current and quick ratio of the financial statements.
These ratios involve current liabilities to calculate. The higher are the ratios, the higher it is more favorable for the company. However, if the company needs more cash, they may approach the finance providers such as banks.
Because of its own interests, the bank will assess the company’s financial performance, i.e., the current and quick ratio. Lower ratios will make the bank reluctant to provide loans.
Other than that, trade payables are a part of the calculation of the company’s credit rating by external evaluators when evaluating the credit ratings of different companies. Large balances of trade payables mean lower credit ratings placed by the evaluators on the company.
To a great extent, a lower credit rating will hint the vendors to provide a limited amount of inventory to the purchasing company.
Recognise and de-recognise trade payable:
For example, the ABC Company purchase goods from XYZ Company amount $5,000 on 1 January 2020. The goods and invoice are delivered to ABC Company on the same day of purchasing. However, the payment will be made on 15 January 2020.
Here is how to trade payable is recognized on 1 January 2020 in ABC Company account,
Dr Inventories (goods) $5,000
Cr Trade payable $5,000
As mentioned above, the company will make the payment to its supplier on 15 January 2020. Therefore, trade payable will have to be de-recognized on the same day.
Here is how the entry will look like,
Dr Trade payable $5,000
Cr Cash/bank $5,000
It depends on the way how the company makes the payment. If the company makes the payment through bank transaction, then credit to the bank, and if the payment is by cash, then the credit is to cash.
Trade payable is derecognized when the payment is made, or we can say the liability is discharged when the payment is made.