Accounts Payable (AP) and Accounts Receivable (AR) are important terms to understand the financial health of a company. It is also important to differentiate between these terms as one term comes under company liabilities, while the other is noted under company assets.
A good understanding of accounts receivable and accounts payable can help businesses efficiently manage their working capital and minimize cash flow issues.
What is Accounts Payable?
Accounts Payable (AP) is the amount that a company owes to its suppliers and other creditors.
It is an account on a company’s general ledger that represents the obligation to pay off the debt to creditors. This is done by calculating a company's days payable outstanding.
AP includes the purchases made on credit; it does not include long-term debt like a mortgage but can include payments toward long-term debt.
AP is recorded once the business receives an invoice for the purchase of goods and services.
The accounting team records AP as an expense in the company ledger, and the balance sheet shows the total amount of accounts payable.
Once the payment is approved, the accounting team issues payment to the supplier as per the credit period, like 30-days or 90-days.
Setting up a strong AP practice is crucial for business success as it can help businesses save money through favorable payment terms and discounts, cash forecasts, and minimal mistakes in accounting.
Read a detailed guide on accounts payable financing here.
Example of Accounts Payable
Suppose Company A is a tire manufacturer that orders USD 5000 worth of raw materials to process an order for 100 tires. The raw materials supplier sends Company A an invoice for their order, which Company A records in the accounts payable journal entry and notes the credit period for paying the supplier the due amount. Company A credits the supplier’s account by the due date and debits Company A’s inventory asset account by the same amount.
What is Accounts Receivable?
Accounts Receivable (AR) is the amount that is owed to the company by its customers.
It refers to outstanding invoices or a line of credit extended from the company to its customers. AR is listed as general assets in a company’s general ledger.
When a business enters into a sales contract to supply goods or services, it can decide mutually agreed upon terms of payment timelines with the buyer. Once the goods or services are delivered, the AR team of the vendor creates an invoice and records the amount as an account receivable in the company ledger.
If the customer pays the amount within the credit period, the accounting team notes this and that the account is no longer receivable.
In the event that a customer fails to complete the payment according to the credit terms, the accounting team sends a collection notice which may contain the details of late fees that a customer will have to pay.
Example of Accounts Receivable
Company B builds furniture and enters into a contract with a retail store that makes a total purchase of USD 3000 from Company B. Company B sends an invoice of USD 3000 to the retail store and makes a note of it as the accounts receivable in their business ledger.
If the retail store fails to pay within the credit terms of 90 days, Company B will send a collection invoice charging late fees to the retail store.
Why are Accounts Payable and Receivable Important?
Cash flow crunches the closure of 82% of small businesses, according to a US Bank Study.
Accounts payable and accounts receivable are important indicators that help businesses in effectively managing their cash flow.
Managing both enables companies to plan their budget according to upcoming invoices, provides incentives to their customers to accelerate incoming payments, and discover ways to get better terms with their vendors.
They are also vital proofs required to obtain small business loans like the SBA 504 loan.
Proper cash flow management by monitoring accounts receivables and account payables can help businesses to improve their daily working capital.
Tracking accounts receivable and accounts payable will also help businesses make educated decisions and grow their business sustainably.
Accounts Payable vs. Accounts Receivable: Key Differences
Every invoice is payable to one party and receivable to the other party. Both AP and AR are recorded in the company ledger; AP is recorded as a liability, while AR is recorded as an asset.
An understanding of both receivables and payables is required to know about the financial health of the company.
FAQs
Can AP and AR be done by the same person? AP and AR can be done by the same person, but they are usually different departments that manage accounts receivable and accounts payable. They are done by different people to remove the risk of mismanaging accounts.
Is accounts receivable a debit or credit? Accounts receivable is a current asset on a company’s balance sheet. According to accounting rules, debit means assets, and credit means liabilities. So, accounts receivable is a debit.
Is accounts payable a debt? Yes, accounts payable is a short-term debt that a company owes to its suppliers or creditors.
What is accounts payable also known as? Accounts payable is also called bills payable and is usually one of the largest current liability accounts in a company.
What are short term notes payable? Short term notes payable are obligations made in writing to pay a specified amount plus interest within a year. Notes payable differs from accounts payable in that accounts payable are short-term liabilities covering daily expenses while notes payable can be both long-term and short-term and are used for substantial purchases.
Do I send an invoice to accounts payable or receivable? If a company is issuing an invoice, its finance team will note the payment in accounts receivable. If the company is a buyer in the transaction and paying for the invoice, then its finance team will note the payment in accounts payable.
What are examples of accounts payable? Accounts payable examples can include expenses involved in purchase of raw materials, fuel, leasing equipment, licensing, transportation and logistics, and any other business expense.
What are examples of accounts receivable? Accounts receivable examples include sale of goods, delivery of services, money lent, and deferred revenue.