Accounts payable refers to the amount due to the company’s creditors or suppliers. An account within the general ledger represents the company’s obligation to pay off short-term debt. The total outstanding amount reflects as accounts payable(AP) balance on the balance sheet. Any movement in the AP account appears on the cash flow statement. Management decides on when to pay the outstanding bills. They often pay the outstanding amount close to its due date to increase cash flow.
Nature of Accounts Payable
Accounts Payable are debts and should be paid off by the due date to avoid default. The accounts payable appear as current liabilities on the balance sheet of any given company. Accounts Payable are short-term debts due to the creditors and are mainly addressed as IOU from one business entity to another. IOU is a Phonics acronym for I Owe You. It is generally viewed as an informal agreement rather than a legal document. The receiving entity of the AP amount records the transaction under accounts receivables on the asset side of the balance sheet.
What does Accounts Payable Indicate?
Accounts Payable is an important indication on a company’s balance sheet. It brings to light the credit habits of the company and its payment patterns. If there is a rise in the value of AP, it means the company is purchasing goods or services on credit. On the other hand, if there is a decline in the value of AP, it indicates the company is clearing debts at a faster rate than credit purchases. Managing accounts payable is crucial in managing the cash flow of the business.
Ways to Generate Cash Flow Statement
There are two ways to generate the cash flow statement: direct and indirect.
- The direct method listing actual cash inflows and outflows during the reported financial year.
- The indirect method incorporates additions and deductions in the balance sheet following the net income or loss resulting from operating activities in the cash flow statement. Large corporations more commonly use the indirect method.
While preparing the cash flow statement using the indirect method, the net additions or deductions in account payable reflects in the cash flow from operating activities. Management has the power and ability to manipulate the company’s cash flow using AP to a specific limit.
For example, suppose the management of X company decides to increase the cash reserves for a limited period. In that case, they can extend the time taken to pay the outstanding amount to the creditors. However, it is vital to meet the bills by the expected deadline. Sometimes a slight delay with prior notice may not necessarily affect the relationship with the suppliers.
How to Record Accounts Payable?
While recording entries in the general ledger, following double-entry bookkeeping, one must ensure each transaction is recorded on the debit and credit side. A Debit entry increases the expense account and the asset account. A credit entry increases equity account, revenue, and liability.
The accounts payable is recorded as a credit entry when the invoice is received. At the same time, the service that was purchased on credit is a debit entry because it is an expense. If the item purchased is a capitalizable asset, a debit entry would be made to the asset account. Once the payment is cleared, the accountant offsets the amount from the debit account to reduce liability. The netting credit entry for the same transaction would be made in the cash account, reducing the cash balance.
Example of Accounts Payable Entry
For example, if a company gets office supplies worth Rs 1000. The Accounts Payable department will receive the invoice, and they record Rs 1000 credit in accounts payable and Rs 1000 debit to office supply expense. The Rs 1000 debit to office supply expense will show on the income statement, meaning the company will record a purchase transaction without paying the money for the service obtained. As per accrual accounting, you must record the expenses incurred and not when the payment is made. When the company clears the bill, Rs 1000 credit entry is made to the cash account and a debit entry for Rs 1000 to accounts payable.
A company may have many due open payments to the creditors at a given time. All outstanding payments are recorded as accounts payable. The balance in accounts payable reflects the total amount the business owes its short-term lenders or suppliers. The Account Payables appear on the balance sheet. For example, if the above company also received an invoice for lawn mooing services for Rs100, the total of both in accounts payable will be Rs1100 before paying off debts.
Accounts Payable- An Expense?
Accounts payable is a business term that refers to liability because the company owes money to its creditors. Often people have been mistaken that accounts payable can be accounted as routine operational business expenditure. However, it is incorrect; accounts payable reflects on the company’s balance sheet, and the expenses are shown on the income statement.
How are liabilities and expenses different?
The simplest way to address the difference is by analyzing the action timing. Liabilities are obligations for which a payment has to be made shortly. Expenses are obligations that have been paid for to generate revenue.
Liabilities are reflected on a company’s balance sheet, clearly indicating an easy-to-understand snippet of a company’s financial standing for the given financial year. Liabilities are recorded in the “accounts payable” sub-ledger when an invoice is received for payment. These payables are also referred to as “trade payables.”
A liability account also includes interest owed on loans from creditors, referred to as interest payable. Any accumulated tax obligations of the company are called taxes payable. These are not considered as a part of accounts payable.
Expenses are shown on a company’s income statement, which consolidates revenues and expenses, to derive net income for the given financial year. For example, any expense incurred by the salesperson to generate revenue will be treated as an office expense and not a liability. These expenses may involve lodging, client dinners, fuel, car rentals, and office supplies.
Hope, this clarifies the term accounts payable, what it means and how to record it. Also, check the difference between capital and revenue.