What is Accounts Payable?

As a small business owner, understanding cash management is important. You may automatically think of accounts receivable when you think of cash management, but accounts payable is another crucial factor.

Accounts payable (AP), sometimes called “payables,” refers to a business’s short-term liabilities. In other words, payables are the short-term obligations a company owes to vendors or suppliers. The payables are listed as a current liability on the company’s balance sheet.

When should you use accounts payable?

It’s important to pay close attention to your accounts payable balances. Accounts payable should be used to keep track of the expenses and money owed to suppliers for your essential business processes. These expenses must be paid off within a given time period to avoid default. Here’s an example:

A clothing retailer has issued a purchase order and purchased inventory from a supplier for $5,000. The supplier sends an invoice on June 8th with payment terms of “net 30.” This means the payment is due within 30 days of the invoice date. If the retail company uses AP, they will enter a bill and mark it paid by July 8th. The final step is to debit $5,000 from the inventory asset account.

Here’s another example of when accounts payable is used for the clothing retailer:

The retailer receives a utility bill for $1,200 for their store’s electricity and water usage. The bill is due within 15 days of the invoice date. The clothing retailer will record this bill as an accounts payable entry.

Accounts payable expenses

Accounts payable expenses are different from other types of current liabilities. These expenses often include:

• Transportation and logistics
• Raw materials
• Rent payments
• Utilities
• Advertising expenses
• Licensing
• Services (assembly, subcontracting)

Impact of cash flow on accounts payable

Small business owners must keep a close eye on the accounts payable balance and use a cash forecast to plan the payments. How you handle accounts payable can have a big impact on cash flow.

Every business needs a minimum cash balance to operate. So, managing your accounts payable directly affects how your cash flow is managed. Consider the timing of your cash inflows (accounts receivable) and cash outflows required to pay accounts payables.

Understanding accounts payable and how to record payments

Proper bookkeeping for accounts payable (AP) can be overwhelming, especially if you’re new to the whole concept or not the one sitting down to do the bookkeeping. Even so, understanding how it’s recorded is an important and necessary skill for managing your business effectively.

To manage accounts payable, you may wish to use accrual accounting. With accrual accounting, income is recognized when earned, and expenses are recognized when incurred, regardless of when the income is received or the expenses paid. Accrual accounting provides a more accurate measure of your company’s finances than cash accounting.

To properly use accrual accounting, you will need a double-entry bookkeeping system. This system requires that there must always be an offsetting debit and credit for all entries made. The debit is recorded in one account and the credit in another. Double-entry bookkeeping helps reduce errors.

Let’s look at how this works. The AP liability account is credited when the bill or invoice is received to record an expense. The debit offset will generally go to an account for the item purchased on credit, such as inventory or services. Then, when the bill is paid, the AP liability account will be debited to decrease the account balance, and the cash account, such as a checking account, will be credited to decrease the account balance.

Your company can have many open invoices due to vendors or suppliers at one time. All of these outstanding payments are recorded in accounts payable. So, the AP balance will show you the total amount your business owes to suppliers and short-term lenders.

For example, a clothing retailer runs a marketing campaign and incurs advertising expenses worth $1,200. When the supplier invoice is received, you (or your AP department) will record a $1,200 credit in accounts payable and a $1,200 debit to advertising expenses. The debit will flow through to the income statement so that your business has recorded the transaction even though the cash hasn’t yet been paid. As explained earlier, in accrual accounting, the expenses are recorded when incurred rather than when cash is exchanged. Then your business will pay the invoice, a $1,200 credit will be entered into the cash account, and a $1,200 debit to AP.

Accounts payable vs accounts receivable

Accounts payable and accounts receivable (AR) go hand in hand but are functionally opposites. Accounts receivable refers to the money customers owe your business. AR is considered a current asset. While businesses use AP to record money they owe TO others, AR is used to record money they are owed BY others.

Accounts payable: Best practices & improvement tips

You should monitor your accounts payable to know when to make necessary changes to improve your business outcomes. Some best practices and tips include:

• Streamline and standardize your workflow: Make your AP process more efficient using automation software, improving your relationships with suppliers, and employing digital filing systems.
• Review data regularly: Have consistent visibility on your business’s bottom line. Reviewing your cash flow data consistently will help you identify any red flags and areas for improvement.
• Decrease the AP aging schedule: The aging schedule helps you see when invoices must be paid. Most are due within 30 days, so you don’t want to have many outstanding invoices pile up after 30 days. Make an effort to pay vendors in a timely manner.
• Go paperless: Digitizing the AP process can drastically reduce your manual workload. You also no longer have to have an actual paper trail as audits are performed through software systems.

Accounts payable is only one aspect of cash flow management and shouldn’t be overlooked. Sifting through all of the financial information about your business can be overwhelming, but it’s an important step to take. Here’s where Block Advisors can help lighten your load. We offer tax, bookkeeping, and payroll services to help you get back to what you love.

Speak with a certified small business pro today.

This article is for informational purposes only. The content may not constitute the most up-to-date information and should not be construed as legal advice. 

---