What is accounts payable?
Accounts payable (AP) represents the amount that a company owes to its creditors and suppliers (also referred to as a current liability account). Accounts payable is recorded on the balance sheet under current liabilities.
When a business purchases goods or services from a supplier on credit, payment isn’t made straight away, but is due within 30 days, 60 days, or in some cases even longer. In the first instance, the company will send the supplier a purchase order, after which the supplier will provide the goods purchased together with an invoice requesting payment by a certain date.
When the amounts owed to suppliers and other third parties are not paid within the agreed terms, late payments or defaults occur. This could be due to inefficient invoice processing or challenges within the supply chain.
A key metric when talking about accounts payable is Days Payable Outstanding (DPO). This is used to describe the number of days that a company takes to pay its suppliers. The higher a company’s DPO, the longer it is able to make use of its available cash. Consequently, some companies may choose to extend the payment terms offered to their suppliers in order to improve their working capital position.
Accounts payable vs accounts receivable
Accounts payable is not to be confused with accounts receivable (AR), which refers to the payments a company is due to receive from its customers. As such, accounts receivable is recorded on the balance sheet as an asset, and represents money owed to a company when its customers purchase goods or services with payment due on a future date.
Accounts payable example
Under the double-entry accounting system, a purchasing company will approve an invoice and then record the value of the invoice in the general ledger under accounts payable, with an equivalent debit in the expense account. Once payment has been received, the sum will be debited from accounts payable, with a credit made to cash.
For example, if a company purchases goods for $780, it will record a $780 credit under accounts payable, and a $780 debit to the expense account. Once the company has paid the invoice, it will debit accounts payable by $780, and record a $780 credit to cash.
Accounts payable department
When people ask, “What is accounts payable?”, this might also refer to the department within an organization that processes payments to third parties. Large organizations will have a dedicated department focusing solely on accounts payable management, whereas smaller organizations may have a single team managing both accounts payable and accounts receivable.
The accounts payable department is responsible for processing and managing outgoing payments, as well as engaging with suppliers. Activities will typically include onboarding new suppliers, receiving invoices, reviewing payment details and updating ledger accounts, as well as paying suppliers by the agreed due date and reconciling payments. In addition, accounts payable will be responsible for reimbursing employees for expenses such as travel expenses and petty cash.
An important part of accounts payable’s role is to ensure that robust internal controls are in place to avoid errors, such as duplicated payments or incorrect sums being paid. Payable risk assessment is crucial in this process. Another concern is mitigating the risk of accounts payable fraud schemes, which can include the creation of false invoices, duplicate or overstated employee expense reimbursements, check fraud, and kickback or bribery schemes in which employees receive incentives from vendors in exchange for the purchase of goods or services.
Companies should also be aware of the risks that can arise as a result of conflicts of interest, for example if an accounts payable employee has an undeclared interest in one of the company’s suppliers.
In addition, processes need to be in place to ensure that suppliers are paid on time, in order to avoid late payment fees and the risk of reputational damage which can arise due to tardy payments. Another component of the role is handling any exceptions that may arise, such as failed payments.
Harnessing early payment discounts
Accounts payable also has a role to play when it comes to taking advantage of any early payment discounts offered by suppliers. For example, a supplier might offer terms of ‘2/10 net 30 days’. This means that if the customer pays the invoice within 10 days, instead of the agreed 30 days, they will receive a 2% discount on the stated value of the invoice.
This type of discount can be very attractive to companies that purchase goods and services. To harness discounts in a structured way, the buyer may choose to offer its suppliers early payments via a dynamic discounting solution. This allows suppliers to take early payment on chosen invoices on a flexible basis: the earlier the payment, the greater the discount. In this way, suppliers can fulfil their cash flow requirements, while the purchasing company can invest its own cash in order to earn a risk-free return.
Early payment programs, which include both dynamic discounting and supply chain finance, give you access to affordable liquidity as and when you need it. Last but not least, electronic invoicing techniques can enable suppliers to automate the delivery of their invoices straight to their customer’s ERP system.
Calculating accounts payable is as simple as adding up all of the money currently owed in payments to suppliers in a given time period. For example, if you’ve bought goods or services worth $5,000 from five different suppliers in a 30 day period, total accounts payable for that period is $25,000. However, there are two main other ways of looking at accounts payable that are both more commonly used as a performance metric.
The first, known as accounts payable days or days payable outstanding, represents how long it takes a company to pay its accounts payable in days. The second, named the accounts payable turnover ratio, measures how many times a business pays its creditors during a specified time period.
Accounts payable and accounts receivable are functionally opposites. Accounts payable is the sum total of all short-term liabilities to suppliers and creditors. Accounts receivable is the sum total of all payments due to be received from buyers or customers. This critical difference is most easily represented by where these figures appear on a typical balance sheet, with accounts payable recorded as a liability while accounts receivable is recorded as an asset.
3-way matching (or three-way matching) is a process in accounts payable that checks the details contained on three documents, the purchase order, supplier invoice, and delivery receipt, to ensure they match. In other words, it checks that what was ordered was delivered in full, and that the associated invoice is accurate.
This process is typically carried out before the invoice is paid, as any discrepancies between the three documents that are checked could mean that the order is inaccurate. This can lead to a dispute with the supplier, which will delay payment until it’s resolved.