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, it 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 short-term liabilities of the company and are placed under the current liabilities of the company’s balance sheet.
If the trade payable is not recognized in the entity’s financial statements, the entity should at least accrue the expenses the same as the trade payable that the entity will have to record.
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 certain terms and conditions before supplying them. This is how the market is working.
Different industries will have different terms for the period of payments. However, this period depends on the level of competition among the industry’s vendors. Highly competitive industries will have flexible periods of payment along with providing discounts to purchasing parties.
This may range from 60 to 90 days. Conversely, 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, it will need money for its daily operations, such as purchasing inventory, paying salaries to employees, usual everyday expenses, etc.
In this case, the company may want to borrow money from the bank. However, bank loans to the company are secured against some securities and large interest payments 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 than 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 the ratios, the higher it is more favorable for the company. However, if the company needs more cash, it may approach the finance providers such as banks.
Because of its 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.
Recognize and de-recognize trade payable:
For example, ABC Company purchased 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 purchase. However, the payment will be made on 15 January 2020.
Here is how to trade payable was recognized on 1 January 2020 in the ABC Company account,
Dr Inventories (goods) $5,000
Cr Trade payable $5,000
As mentioned above, the company will pay its supplier on 15 January 2020. Therefore, trade payable will have to be de-recognized on the same day.
Here is what 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 a 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.
The measurement criteria for trade payables:
- Value of goods or services received by the creditor;
- Timing and extent of cash payments for goods and services;
- Private terms of the agreement between the creditor and debtor;
- Relevance of any collateral provided to secure the debt;
- Relevance of any security against non-payment, including letters of credit;
- Accounting treatment consistent with applicable standards and regulations;
- Tolerances for agreed variances in payment terms or conditions.
- The amount due as per invoices or recognized obligations; and
When Should Trade Payable Derecognise From Balance Sheet?
Trade payables should be derecognized from the balance sheet when:
- The creditor has received the goods or services;
- The amount payable has been settled in full;
- The legal title has been transferred to the creditor; or
- There is no further legal obligation towards the debt.
Where Does Trade Payable Go On Balance Sheet?
Trade payables are typically recorded in the current liabilities section of a balance sheet. This is because trade payables are obligations to pay for goods or services that have already been received from a trade supplier.
As such, it is important for businesses to keep track of their trade payable obligations, as failure could result in late payment fees from the suppliers or even reputational damage.
The amount owed is recorded as a credit balance, as the company owes money instead of being owed money by others.
Is Derecognition of Trade Payable Asset or Income?
Derecognition of accounts payable is normally when the company has no obligation to pay the liabilities. Derecognition of liabilities is recorded as debit liabilities and credit assets in the balance sheet or income in the income statement.
For example, when the company pays off trade payable, there should be a decrease in assets. If the derecognition due to the company liability does not exist, the derecognition will increase income in the income statement.