What are Accounts Payable?

During the normal course of business, credit transactions that quite common. This implies that companies procure goods and services at an earlier date, and then the amount is settled later. This gives them an added advantage to companies in terms of cash flows. When a company purchases goods and/or services on credit, the liability that arises, as a result, is referred to as Accounts Payable.

In other words, Accounts Payables can be defined as accounts that need to be settled as a result of goods and services being purchased on credit. It must be noted that accounts payable only include liabilities that need to be settled when a business purchases goods and services on credit, intending to resell. This implies that if there are any other liabilities that a business has concurred over time, they will not be recorded as an account payable.

Accounts payable is disclosed on the balance sheet as a current liability, which needs to be settled by companies over the course of one year. It is disclosed as a sum of all the account payable accounts on the balance sheet. In the subsequent disclosure to the financial statements, the further breakdown of accounts payable is duly mentioned.

Classification

Accounts Payable is classified as a Current Liability on the Balance Sheet. It is represented as the amount of outstanding balances that have to be paid to the suppliers at the end of the given period. In this regard, the question that arises is when current liabilities are actually classified on the balance sheet.

Accounts payable are classified as current liabilities because this amount needs to be settled within the course of one year from the invoice date. It is a short-term liability, and hence, it is classified as a Current Liability.

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The classification of accounts payables properly is quite important for the business, essentially because it gives a snapshot to the users of the financial statements regarding the obligations that need to be honored by the company. In case of incorrect classification of Accounts Payables, there would not be any difference in the totals in the Balance Sheet (or Income Statement). However, it would be equivalent to a material misstatement in the financial statements because it would imply that the amount for Accounts Payable has been significantly understated.

Recognition

Accounts Payables are regarded as Current Liabilities in the financial statements when the risks and rewards associated with holding the inventory are transferred to the party purchasing the goods.

This means that if the purchase has been finalized, the amount can be recorded as Accounts Payable. In other words, Accounts Payable are recorded in the Balance Sheet as soon as Purchases are duly recorded in the financial statements.

Hence, it can be seen that Accounts Payables are recognized as soon as the risk of inventory in terms of obsolescence and wear and tear are transferred to the purchasing party. Regardless of the physical possession of these goods and services, purchase (and subsequently accounts payable) will still be recorded in the balance sheet as soon as the company sends the Purchase Order. That is confirmed by the party selling the goods.

The double entry that recognizes the increase in purchases, as well as Accounts Payable, is mentioned below:

ParticularDebitCredit
Purchasesxxx 
 Accounts Payablexxx

Since Accounts Payable is a current liability account, it has a credit balance. The balance is carried forward from one year to the next. It is constantly adjusted as per new credit purchases and payments made to the creditors. All credit purchases are credited to the Accounts Payable Account, whereas all payments made to the debtors are debited in the Accounts Payable account. A sample Accounts Payable General Ledger Account is mentioned below:

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20192019
Amount Paid to Creditors (Bank)                       XXXXAccounts Payable (Balance BF)                           XXXX
Accounts Payable (Balance CF)                          XXXXCredit Purchases                                                   XXXX
  
 2020
 Accounts Payable (Balance BF)                           XXXX

Measurement

Accounts Payable are measured and subsequently recorded in the Balance Sheet depending on the invoiced amount. This includes all the trade discounts that are offered. In the case where a cash discount is offered (pre-payment) discounts, in that case, it tends to be adjusted only when it’s availed.

Therefore, this implies that accounts payable are measured based on the cost at which it has been purchased. The invoice amount is used to record the subsequent balances in the Balance Sheet.

Example

The concept of accounts payable is illustrated in the following example:

Henry Inc. is a clothing retailer, which purchases goods on credit from various clothing manufacturers and then sells them at the retail outlet. For the year ended 2019, they had the following balances:

  • Purchases: $500,000
  • Payments made to the suppliers: $200,000

The opening balance on Accounts Payable Accounts was $100,000.

In the example above, it can be seen that the closing Accounts Payable Balance for Henry Inc. is going to be calculated as follows:

Accounts Payable (Opening Balance): $100,000

Add: Credit Purchases for the year: $500,000

Less: Payments made to suppliers for the year: ($200,000)

Accounts Payable (Closing Balance): $400,000

Subsequently, the closing amount for Accounts Payable will be mentioned in the Balance Sheet as a Current Liability.

Difference between Accounts Receivable and Accounts Payable

Accounts Receivable and Accounts Payables are accounts that exist within the company due to credit sales and purchases. However, accounts receivables constitute the amount of money that the company needs to receive from the debtors. This is classified as a Current Asset in the company.

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It is important to understand that Accounts Receivables are the amounts that need to be recovered from the debtors, whereas Accounts Payable is the amount that needs to be paid to the creditors. Accounts Payable arise from credit purchases, whereas Accounts Receivable arise from credit sales.

The double-entry accounting system for recording Accounts Receivable is as follows:

ParticularDebitCredit
Accounts Receivablexxx 
 Salesxxx

Importance of Accounts Payable in the Balance Sheet

The primary purpose of Accounts Payable in the Balance Sheet is to ensure that users of the financial statements have a clear idea regarding Accounts Payable and the amount that needs to be paid to the creditors instead of credit purchases. Other than that, the Accounts Payable figure is also significant because of several other reasons. These reasons are as follows:

  • From an investor’s perspective, it is important to know how much liabilities that the company has. It is also important for an investor to realize how much of these liabilities current liabilities, and what proportion constitutes of long-term liabilities are.
  • It is also important to estimate the cash flow of the company in the coming few months. Since Accounts Payable are current liabilities, they need to be settled in a period of less than a year. Therefore, Accounts Payable gives a fair idea regarding the cash flow position of the company, since it is used in calculating important ratios including the Current Ratio, and the Quick Ratio.
  • From the perspective of creditors, and other lenders, Accounts Payables gives an idea regarding the credit worthiness, as well as the risk assessment of the company.

Therefore, Accounts Payable helps external stakeholders make important decisions regarding the company. Similarly, it is also important to realize that for internal decision-making too, Account Payable management is an important task because it helps companies manage their credit policies accordingly.