What is Accounts Payable? Definition, Examples, FAQ

What-is-Accounts-Payable

Accounts payable (AP) is a commonly used financial term that describes short-term debt and obligations to company’s vendors or suppliers for the goods and services bought on credit. 

Since those purchased items are usually paid with a delay of 30 up to 90 days, it is the money that the company owes. The sum of all accounts payable is represented on a balance sheet as a current liability up until the moment the transaction is finished with payment.   

Well-organized and accurate accounts payable records are crucial to the company’s financials, as they affect cash flow and liquidity.

The term AP is also used as a name for the accounts payable department — a financial sublet that manages AP processes. These teams usually do their work manually, with some taking a step further and implementing automated solutions for a seamless workflow.

Examples of Accounts Payable

Accounts payable item is recorded in company’s books every time when a vendor or supplier issues an invoice that has not yet been paid. Depending on your business needs, a vast array of items can be purchased, but most commonly examples of AP include some of the following:

  • Raw materials — Especially in manufacturing industries where large amounts of materials are used to finish the production process it is impossible to buy the entire supply with instant payment, so those items are shown in the books as account payable.
  • Power / Energy / Fuel — Typical utility bills are also accounts payable because their consumption is prior to the payment.
  • Transportation and Logistics — Many companies outsource their transportation and logistics needs to specialized firms, and those costs are recorded as accounts payable.
  • Products and Equipment — Some businesses require a certain infrastructure to supply their clients with a service. In case that equipment is purchased from a third party and not paid until the end customer pays for service, then that equipment also falls under AP category.
  • Leasing — Equipment mandatory for the business can also be leased instead of bought, so leasing invoices qualify as accounts payable.
  • Licensing — Any subscription-type service can be considered as accounts payable. Most often companies need licensed software products for their daily operations. Some of those costs are one-time payments, but a lot of subscription-based services are billed monthly or weekly. 
  • Services — Any type of outsourced service or subcontracted work is accounts payable, as long as service is provided with a delay in payment.

Accounts Payable Process

The AP process has its workflow, and the full cycle includes various steps taken by the personnel of the accounts payable department. Depending on the nature of the business, some businesses require involvement of one or two documents prior to issuing invoice: purchase order and delivery receipt. But the real accounts payable process begins when a vendor or supplier submits an invoice for delivered goods or services. After that AP team conducts the following:

1. Data collection Invoices are received, reviewed, matched via 2-way or 3-way matching in case there was a purchase order and/or delivery receipt. If everything is correct, then the invoice is ready to be processed for payment approval.

2. Approval Data is entered in ERP or accounting software system with basic information (vendor info, amount, quantities, code for general ledger)

3. Payment authorization Includes setting payment details such as payment date, amount and getting final approval from the person in charge to process the payment execution.

4. Payment finalization Invoice is paid and usually the vendor is notified about that transaction.

Additional steps include archiving invoices, registering debit vs credit balance change for accounts payable and other balance sheet adjustments.

AP process is often a manual, paper-based work of accounts payable team, and is very prone to human error. Any oversight of details in the entire process can result in inaccurate payments, late payments or AP frauds.

Accounts Payable FAQ

Here are some of the common questions related to accounts payable:

Accounts Payable vs Business Expenses

Business expenses are costs incurred in an attempt to generate revenue and are presented on the company’s income statement. Accounts payable are presented on a balance sheet as a current, short-term (up to 90 days) liability.

Accounts Payable vs Accounts Receivable

Accounts receivable (AR) is the opposite term of accounts payable.

Accounts receivable represents the money that customers owe to the company for purchased goods and services, while accounts payable is the money company owes to its vendors. The difference occurs in how those items are recorded on the balance sheet: accounts payable as a current liability and accounts receivable is recorded as a company’s short-term asset.

In the double bookkeeping system one transaction has two sides: buyer and a seller. An invoice issued by a seller is recorded as accounts payable in buyer’s books, while the seller records it as accounts receivable at the time when payment is received.

Accounts Payable vs Trade Payable

While both those terms describe the money owed by the company and are often mistaken for one and the same, they are slightly different in their nature. Trade payable is used to describe debts for goods that are an inventory, and accounts payable represent all short-term obligations.

Let’s see this correlation on an example of an IT retail store: The store buys laptops directly from a laptop manufacturer or factory. The invoice for those laptops is recorded on a retail store’s balance sheet as account payable, but since it’s a merchandise that will be sold to the end customer, for retail store it is an inventory item, therefore a trade payable. If the same retailer buys a cleaning service from a company that cleans business premises, the invoice will also be account payable, but it won’t fall under the category of trade payable.  

Is Accounts Payable a Debit or Credit Entry?

It could be both, depending at which moment in time the transaction is recorded in double-entry bookkeeping. When the invoice is initially issued it should be recorded as credit entry because it’s a liability and the company still didn’t pay for it, but when that invoice is paid the company needs to debit accounts payable to decrease that credit balance.

How to Calculate Accounts Payable

Most common metric used to calculate AP is accounts payable turnover ratio, a measure that shows a company’s short-term liquidity. It’s a formula that calculates the number of payments to the vendors during a specific period. It’s also a good indicator whether the company has enough cash or revenue to fulfill its short-term obligations.

What is 2-way or 3-way Matching in Accounts Payable?

2-way and 3-way matching is part of the accounts payable process and invoice validation. If the business transaction with a vendor starts with a purchase order and is followed by invoice, in that case there are only two documents and the AP department conducts 2-way matching to connect these docs together. Some purchasing items additionally have a delivery receipt in between that comes when goods are delivered to the buyer but prior to invoice and it’s a 3-way matching.

Who is Responsible for Accounts Payable?

Finance departments usually have dedicated AP teams. The main task of accounts payable teams is to manage the entire AP process, including but not limited to:

  •       Collecting purchase orders, received notes, vendor invoices
  •       Entering items to the records
  •       Conducting 2-way or 3-way matching
  •       Collecting approvals
  •       Payments
  •       Storing

Why Automate Accounts Payable?

Accuracy in bookkeeping is essential to lead a successful and healthy business and finances are a complex system to manage. Regardless of the company size, whether it’s big or small, it involves a lot of paperwork, human resources, and a great attention to details. The risk only grows with mid-sized and large companies, where these factors are multiplied with a larger number of suppliers, vendor invoices and people whose job is to run financial operations smoothly.

Accounting is somewhat specific in terms of how much manual work is required. The AP process especially is very intensive and time-consuming, with a high risk of human error that can basically lead to financial catastrophe.

So, is there a way to reduce risks and increase accounting productivity? Good news is that there is, with the help of technology and automation.

Accounts payable automation provides companies with a better and more accurate way to track and manage their AP process. Based on a digital automated workflow, this technology enables capturing, streaming and processing of vendor’s invoices without manual human intervention.  

Automated AP has a significant list of benefits. One of the most important is it saves time for your employees, giving them a chance to work on more demanding, priority tasks. It takes around a few minutes for an employee to process a single invoice manually, while automated software does the same work in a matter of seconds with much higher accuracy.

Eliminating manual work that can be done automatically can make a huge difference in your everyday management of business operations and eventually can save you both time and money.    

Choosing the right software for your business needs makes all the difference. Learn more about how Dokka can help you to improve your AP process or book a 30 minute demo to get even better insight.

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