What is Accounts Payable?
The term “accounts payable” (AP) refers to the accounting record of a company’s short-term obligations in the ledger about payments to its suppliers(for the purchase of raw material) and other creditors. Typically, companies assign a department or division to maintain AP records. Please note that accounts payable only come into play in the case of accrual accounting, and this line item is not relevant in the case of cash accounting.
Generally, companies can purchase raw materials on credit owing to their long and healthy relationship with the suppliers. The outstanding balance of these credit purchases at a specific point appears in the balance sheet under the current liabilities section as AP. The companies eventually pay these liabilities in time. In most cases, analysts consider accounts payable as a form of debt extended by the suppliers or creditors that must be paid off to avoid default.
Role of Accounts Payable
The AP plays the following essential roles in the corporate world:
- It helps in tracking whether or not the vendor payments are made timely. Payments within the agreed time ensure healthy and positive relationships with suppliers.
- It facilitates the maintenance of the highest level of accuracy of creditor information.
- It helps in exploring ways to reduce costs and improve the bottom line.
Accounts Payable Process
The process can be broken down into four significant steps:
- Invoicing: In this step, the invoice is created. The invoice contains various information about the purchase, such as the number of goods, date and the validity of the bill, name of the vendor, authorizations, etc.
- Recording: In this step, the general ledger accounts are updated, wherein an expense entry is recorded in the books of accounts. This step usually requires managerial approval as a precautionary measure.
- Payment: In this step, the payment is made to the suppliers or creditors as and when they become due. The payment date is decided on mutual understanding between the purchaser and the vendor. In this step, the required documents are verified (such as the authorized person’s signature, details of the vendor’s bank account, original bill, and purchase agreement) before the payments are processed.
- Closure: Once the due payments have been made, the vendor’s ledger account has to be updated in the books of accounts with the information of the payments, which will reduce the obligation to the vendor. In other words, the amount captured under AP will decline.
Different examples are mentioned below:
Let us take the example of ASD Inc. to illustrate the concept of AP. The company purchased raw materials from ZXC Inc. (supplier) for producing its end products. The total purchase amount was $50,000, while the company had paid only $20,000 in cash, and the remaining raw material was purchased on credit. As per the purchase agreement, ASD Inc. will be entitled to a 2% discount on the total purchase if the credit amount is paid within 30 days of the transaction. Determine the accounts payable if the remaining amount is to be paid within 30 days.
- Given, Total purchase = $50,000
- Cash purchase = $20,000
- Discount = 2%
If the payment is not to be done within 30 days of the transaction, then AP can be calculated as,
It is calculated as
Accounts Payable = Total Purchase – Cash Purchase
- AP = $50,000 – $20,000
- AP = $30,000
If the payment is to be done within 30 days of the transaction, then the AP can be calculated as,
AP is calculated as
New Accounts Payable = Total Purchase * (1 – Discount) – Cash Purchase
- New AP = $50,000 * (1 – 2%) – $20,000
- New AP = $29,000
Therefore, the AP is $29,000 if the payment is to be made within 30 days of the transaction.
Let us take another example to illustrate the use of AP in working capital. Let us assume that XYZ Inc.’s total purchase for 2019 was $150,000, while the AP at the beginning and the end of the year was$80,000and $90,000, respectively. Calculate the accounts payable days for 2019 based on the given information.
- Given, Total purchase = $150,000
- Opening AP = $80,000
- Closing AP = $90,000
Average AP for the year can be calculated as,
Average AP= (opening Accounts Payable + Closing Accounts Payable) / 2
- Average AP = ($80,000+ $90,000) / 2
- Average AP = $85,000
Accounts Payable Days for the year can be calculated as,
Accounts Payable Days = Average Accounts Payable / Total Purchase * 365
- AP Days = $85,000 / $150,000 * 365
- AP Days = 206.83 ~ 207 days
Therefore, XYZ Inc.’s AP days for the year 2019 were 207 days.
AP is a fundamental concept that any management should be able to comprehend to run the business smoothly. The importance of the idea can be explained with the help of the following points:
- A well-organized AP system ensures no payment is missed and the due dates are never breached.
- Timely payments ensure a healthy relationship with the vendors, resulting in the uninterrupted supply of raw materials and smooth conduct of the business.
- It can help maintain optimal liquidity through better cash flow management, such as payment on the due date, use of credit terms offered by the vendor, etc.
- A strong AP process can help in the detection of frauds and thefts at an early stage.
So, it can be seen that accounts payable is an essential part of a well-managed organization, where they can leverage their healthy relationship with the vendors or suppliers to grow their business. Nevertheless, please remember that AP can only be seen if the organization follows the accrual method of accounting.
This is a guide to Accounts Payable. Here we also discuss the introduction and accounts payable process along with the importance and examples. You may also have a look at the following articles to learn more –