What is the Difference Between Accounts Payable and Accounts Receivable?
Accounts payable and accounts receivable perform opposite functions in a financial department. Accounts payable is the money a business owes for goods and services purchased, while accounts receivable is the money that other entities (usually customers) owe a company.
Accounts Payable vs Accounts Receivable
When it comes to bookkeeping and accounting, confusion often arises between the functions of accounts receivable and accounts payable. The two types of accounts are very similar in the way they are recorded in the general ledger.
However, it’s important to differentiate between the two on a company’s balance sheet because one is a liability account and the other is an asset account. Mixing them up can result in a lack of balance, less working capital, or worse, bad debt. All of which can carry over into your standard financial statements.
Accounts payable (AP) is considered a liability account as it keeps track of all funds a business owner is liable for when transacting with a third party. A company records the outflow of money it owes to vendors and suppliers for goods and services it received on credit.
A common example of an accounts payable account is a mortgage. A contract is signed to repay a loan over a period of time in the form of installments. Payment terms are established with a solid due date each month.
In some cases, early payment to a vendor can result in discounts on the debt owed. Other examples of AP transactions include everything from office supplies to income taxes and any short-term debt.
The Accounts Payable Process
There are five key steps associated with the AP process. For a larger business, a significant amount of time may lapse between these five tasks:
- Receival – After goods or services are purchased from another business, a company will receive an invoice requesting payment.
- Record – The next step is recording the invoice into the accounts payable ledger. If you have accounting software, this process should be automatic through technology like invoice scanning and optical character recognition (OCR).
- Match – Depending on your process, the invoice may need to be matched with a purchase order, shipping receipts, and/or inspection report.
- Approval – The invoice must go through a set of controls and an approval process to ensure the payment is warranted and accepted as a debt.
- Payment – The final step is to ensure the invoice gets paid, on time, and in the correct amount. Once payment is made, the entry should be removed from the account.
What is Accounts Receivable?
Accounts receivable is a current asset account in which a business records the amounts it has a legal right to collect from customers who received services or goods on credit. It’s an income statement that keeps track of all the money third parties owe you and the inflow of cash to the business. This can be any entity including banks, companies, and individuals who owe you money.
A common example of an accounts receivable transaction is interest receivable, which you get from making investments or keeping money in an interest-bearing account.
The Accounts Receivable Process
The AR process flow is fairly straightforward. There are three main steps that an AR team must go through when looking for a payment. These are:
- Send -After all work has been completed an invoice is immediately sent to the customer.
- Track – Invoices are tracked on a regular basis through a trial balance. When payment is not received, reminders are sent out and additional action may be taken (i.e. phone calls or collections).
- Receival – When a payment has been received, the AR department will ensure it is the correct amount and record it in the ledger as “paid.”
The Symmetry of Accounts Payable and Accounts Receivable
Whether it’s a small business or corporate finance, AP and AR function the same way and both are required for a full transaction.
This is how it works…
Company A sells merchandise to Company B on credit (with payment terms of 30 days). Company A then records the amount with a credit to sales and a debit to accounts receivable.
Company B records the purchase as a credit to accounts payable. When the amount of the credit sale is remitted, they will debit the liability in the AP ledger and will credit cash.
At this point, Company A will debit cash and will credit the current asset.
This shows there are two sides to every transaction, which is referred to as symmetry.
At the time of the sale:
- Company A reports a sale and a current asset
- Company B reports a purchase and a current liability
At the time of payment:
- Company A reports a cash increase and an AR decrease
- Company B reports a cash decrease and an AP decrease
Every transaction done on credit has to have an element of both accounts payable and accounts receivable. In this case, since Company A sells on credit to Company B, they are considered the “creditor” and Company B is the “debtor.” This means, in every transaction, there is always AP and AR involved.
Understanding these two concepts is critical in business. This is especially the case if you are just starting out and doing a lot of transactions with credit (i.e. “on account”). You must be able to identify both processes to reduce stress in the long run.
Accounts receivable and accounts payable play a major role in a company’s cash flow. Late payments should never be the norm. It’s critical to have a full understanding of what and who you owe. Missing payments can lead to interest and strained relationships.
Too much cash languishing on a balance sheet does not leave a business with enough capital to reduce debt and invest in growth. As a result, streamlining both processes can have a positive effect on the financial health of an organization, improve cash flow, and drive revenue.