Table of Contents
- What is Accounts Payable?
- How Does the Accounts Payable Process Work?
- Accounts Payable in Accounting
- Accounts Payable vs. Accounts Receivable
- Accounts Payable vs. Trade Payables
- Examples of Accounts Payable
- Take Control of Your Accounts Payable with Automation
Whenever your business receives an invoice from a vendor, that transaction goes through accounts payable. But this process requires trust and credit, so you need a reliable process for tracking invoices and paying bills. Overseeing accounts payable inflow and outflow enables a more accurate record of your organization’s cash flow.
Paying your vendors, suppliers, and other partners on time is key to good business. By keeping track of your accounts payable, you will understand your company’s cash flow, collect crucial data for better financial reporting, and avoid amassing too much debt.
What is Accounts Payable?
Accounts payable refers to goods or services that were purchased on credit, for which the customer still owes the supplier the actual money. Your company’s accounts payable balance is the sum of all outstanding amounts that have not yet been paid to vendors.
Accounts payable (AP) is a universal term that describes both a business account and a department that handles invoices. It represents a specific account in the general ledger that describes your organization’s obligation to pay short-term debts to suppliers, vendors, or creditors. The full accounting entry of these transactions appears under current liabilities on a balance sheet.
How Does the Accounts Payable Process Work?
The AP department has a set procedure they must follow before releasing payments to vendors and creditors. These guidelines help keep the processes streamlined and transparent to avoid document falsification or financial fraud at any possible point.
For example, Company A needs to buy new manufacturing equipment, so they issue a purchase order for $20,000. Once the owner, CFO, or an employee with financial responsibility approves the purchase requisition and the procurement department or owner approves the PO, Company A places the order with a vendor.
The vendor sends an invoice for $20,000 that is then recorded in accounts payable. The AP team reviews the invoice to verify that the information is accurate and that the company received the correct order. After the invoice is approved, the AP team will send payment in full, or in part, as per the agreement with the vendor.
As business relationships grow over time, all terms and conditions must be clear. A reliable accounts payable workflow establishes brand trust and strengthens business relationships.
The AP process includes:
- Receiving invoices
- Verifying invoices
- Updating records
- Making payments
When a company purchases goods or services, the AP team receives an invoice. This helps them keep track of quantity, current pricing, dates, and other essential details of the transaction.
When an AP team is run manually, the invoice data must be input into an accounting system. If you’re using AP automation software, the invoice is generally scanned with a process known as optical character recognition (OCR).
It is important to ensure all invoice data is correct, so your company only pays legitimate bills.
The AP department uses supporting documents like the purchase order, quote, and delivery receipts to verify that the invoice is accurate. Other important details include:
- Vendor name
- Billing address
- Due date
AP software typically expedites this process and sends invoice approvals to the appropriate parties.
Once the company has received all invoices, the AP department must keep the records current by adding debits and credits to the correct accounts. Depending on a company’s operating policies, updating records requires management approval to keep the process transparent at every touchpoint.
The accounts payable department is responsible for making timely payments to all suppliers, creditors, and supply chain partners. The team prepares and reviews the necessary documents and designated managers approve invoices before initiating payment for invoices. To ensure everything is running smoothly, CPA firms conduct an annual audit of financial statements.
Accounts Payable in Accounting
Accounts payable is a form of accrual accounting that requires double-entry bookkeeping. Unlike cash-basis accounting, accrual recognizes that debts are not always paid right away, and must be recorded and tracked as accounts payable or another liability. In this case, supplier invoices are recorded as debits for inventory and fixed assets on your company’s balance sheet or expenses on the income statement and the accounts payable entry to add the supplier invoice is a credit.
The amount payable is primarily an IOU (short-term liability) from one company to another. The creditor will record the transactions in their general ledger as an asset.
At any given time, the AP balance appears in the current liabilities section of the balance sheet. It is the responsibility of the company to pay off this short-term debt within a specific time frame to avoid financial defaults and late payments. Below are four other responsibilities of accounts payable:
Cash Flow Management
Accounts payable is a significant aspect of a balance sheet and reflects how quickly a business is paying down debt. Your cash flow is important when growing a business. There are two expected scenarios with AP:
- Your company’s AP increases: This means that management is making more purchases on credit than paying cash or delaying payments.
- Your company’s AP decreases: This means that the company is paying off debt faster or purchasing less on credit.
Managing a liability account is vital for positive cash flow throughout the year. Companies strive to keep good cash flow by paying off AP as quickly as feasible. This is to avoid accruing interest or late fees and earn early payment discounts.
Early Payment Discounts
Some suppliers provide early payment discounts if a company settles an invoice earlier than the due date. Some vendors include the payment term “1/10, n/30” in their invoices. This means that buyers who pay within 10 days, instead of waiting until the due date, are entitled to a discount of 1% on the amount of money owed.
Other suppliers offer more significant discounts, such as a “2/10, n/30” payment term. Buyers who remit the amount owed within 10 days may get a 2% discount on the amount owed.
Accounts Payable Turnover Ratio
The rate at which your company settles its accounts payable in any given time period is your accounts payable turnover ratio. The ratio is determined by dividing your company’s total amount of supplier purchases on credit by the average accounts payable.
For example, if Company A’s total supplier purchases, with credit terms, amount to $60,000 and the average accounts payable is $4,000, Company A’s accounts payable turnover is 15 times per year.
A high turnover ratio means a company pays its bills in a short period of time. In contrast, a lower turnover ratio could suggest that a business is struggling to pay its invoices, although this isn’t always the case.
If a company is behind on a payment, a business owner can ask the vendor to reclassify the account payable as a long-term note. This payment term is for accounts due in 12 months or more. The debt should no longer reside in a short-term expense account.
Typically, long-term notes involve an added interest payment. Whether a vendor agrees to a long-term note depends on the company’s relationship with the vendor.
Accounts Payable vs. Accounts Receivable
Accounts receivable is the opposite of accounts payable. Accounts receivable (AR) is a current asset account that tracks the money that is owed to your company, usually from customers for your goods and services.
When your company, which will be the payer, makes a credit transaction, it records an entry to accounts payable while the payee records an entry to accounts receivable.
Accounts Payable vs. Trade Payables
Although these terms are sometimes used interchangeably, they are slightly different scenarios. Trade accounts payable or trade payables is the money that you owe your vendors for inventory-related expenses, like business supplies or inventory materials. Trade payables fall under accounts payable, and some companies simply combine the two into one accounts payable process.
Some examples of trade payables include:
- Raw materials purchased by manufacturers
- Ingredients purchased by restaurants and cafes
- Clothing sold by retailers
- Parts purchased by automotive manufacturers
- Office supplies
Examples of Accounts Payable
The accounts payable process is found across many industries. Here are a few examples of accounts payable scenarios that you might encounter:
- Production materials
- Subscription or installment payments
The AP department has a wide variety of responsibilities beyond simply managing vendor invoices. In large companies, accounts payable is its own department; in smaller companies, accounts payable and accounts receivable are often combined. Regardless of the company’s size, the AP department performs these critical tasks:
Companies often require teams to travel for business, and the AP department manages these expenses. Depending on company policy, the department may process reimbursement requests and handle meal expenses for employees when they travel. Upon the employee’s return, the AP department accounts for the funds (typically through an expense report submitted by the employee) and settles all reimbursement claims.
The AP department is responsible for managing internal payment reimbursement such as:
- Distribution control
- Petty cash
- Office supplies
- Sales tax exemption certificates
Petty cash covers minor expenses such as lunches and transportation.
The AP department also handles the tax exemption certificates issued to managers to ensure that sales tax is not added to business purchases.
The department must manage contact information for various vendors, Form W-9, payment terms, and more. In accordance with the company’s internal policies, the AP department either oversees pre-approved purchases or verifies the procurement after it has been made.
In addition to these activities, the department also manages a month-end due date report that show the company’s current outstanding balances. This is called an accounts payable aging report and can be used to collect past due payments.
To remain competitive in the industry, companies need to reduce expenses to improve cash reserves. The finance and AP teams will devise strategies to increase profitability without taking on excessive debt.
Since AP is the point of contact for suppliers, they can also offer discounts to build long-term business relationships. These strategies are mutually beneficial for both parties and help a company grow.
A company’s cash and assets must be safeguarded, which is why internal controls within the accounts payable process are critical.
Internal controls prevent the company from:
- Paying inaccurate and fraudulent invoices
- Paying a vendor twice
- Paying without ensuring that all invoices are accounted for
To avoid errors and fraud, a business may implement checks and balances, like:
- Segregation of duties: Ensures that no one employee can single-handedly prepare and approve a payment
- Separation of procedures for registering new vendors and entering vouchers: Guarantees that an employee cannot register themselves as a vendor and pay themselves without approval from other employees
- Addition of vouchers: Certifies an approval procedure’s completeness
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Take Control of Your Accounts Payable with Automation
The accounting process is highly subject to human error, especially during manual data entry. Paper invoices also cause problems because these documents can get lost or duplicated. Such issues result in a high cost-per-invoice metric. That’s why companies are turning to accounts payable automation to streamline AP business processes.
Tipalti is accounting software that can help a business of any size implement AP automation. The system enhances the AP process and provides services like:
- Touchless invoice processing: Tipalti has built-in optical character recognition (OCR) technology supported by layers of machine-learning algorithms to scan, capture, and process invoice data effortlessly.
- Software designed for two-way and three-way purchase order (PO) matching: Tipalti simplifies PO automation, eliminates overspending, and strengthens a company’s financial controls.
- Tipalti Pi℠: Tipalti’s integrated payables intelligence platform is designed to enable controllers to proactively reduce process risks and errors.
- Tipalti Detect™: Tipalti’s integrated fraud management solution prevents fraud and mitigates risk. Tipalti offers detailed payee monitoring and tracks a wide variety of data points to uncover potential fraudsters.
- Enhanced vendor and supplier management: Tipalti’s integrated supplier hub streamlines manual data entry by shifting the work of collecting and maintaining accurate vendor data to suppliers.
- Payment reconciliation and cost savings: Forgo stitching bank statements and spreadsheets to reconcile payments. This feature speeds up financial close, thereby reducing costs.
No matter how much we automate, AP will always require a human touch. Accounts payable teams and cash management professionals are vital assets for a business, helping to ensure financial stability every step of the way.