Accounts receivable and accounts payable are the yin and yang of business: When revenues andexpenditures stay in healthy equilibrium, the company can seize growth opportunities, andrelationships with customers and suppliers remain on a positive footing.
A company’s accounts payable (AP) ledger lists its short-termliabilities —obligations for items purchased from suppliers, for example, and money owed to creditors.Accounts receivable (AR) are funds the company expects to receive from customers andpartners. AR is listed as a current asset on the balance sheet.
Lenders and potential investors look at AP and AR to gauge a company’s financialhealth.Income is important, and so is prudent spending to grow the business and retain customers.Mismanagement of either side of the equation can adversely affect your credit and,eventually, the stability of your business.
What Is Accounts Payable (AP)?
A company’s accounts payablescomprise amounts it owes to suppliers and other creditors — items or servicespurchased andinvoiced for. AP does not include, for example, payroll or long-term debt like a mortgage—though it does include payments to long-term debt.
Accounts payable are typically recorded upon receipt of an invoice based on the payment termsboth parties agreed to when initiating the transaction. When a finance team receives a validbill for goods and services, it is recorded as a journal entry and posted to the generalledger as an expense. The balance sheet shows the total amount of accounts payable, but it doesnot list individual transactions.
Once an authorized approver signs off on the expense and payment is issued per the terms ofthe contract, such as net-30 or net-60 days, the accounting team records the expense aspaid.
AP departments are responsible for processing expense reports and invoices and for ensuringpayments are made. A skilled AP team keeps supplier relationships positive by making surevendor information is accurate and up-to-date and bills are paid on time. The team can savethe company money by taking full advantage of favorable payment terms and availablediscounts. A strong AP practice contributes to business success by ensuring cash forecastsstay accurate, minimizing mistakes and fraud and generating reports forbusiness leaders and third parties.
Accounts Payable Example
Say on-trend eyewear maker StyleVision orders $500 worth of new frames from its wholesalesupplier, Frames Inc., which sends the invoice on Aug. 15 with net-30 terms and no discountfor early payment. StyleVision’s bookkeeper creates an accounts payable journal entryandcredits Frames Inc.’s account $500 by Sept. 15, then debits $500 fromStyleVision’sinventory asset account.
How to Record Accounts Payable
Companies may use either the accrual or cash-basis accounting method for recording AP.
In accrual accounting,when finance teams record all unpaid expenses, they act as placeholders for cash events. Forinstance, say our eyewear maker decides to initiate a new $1,000 purchase from Frames Inc.and agrees to pay 50% of the cost upfront and the remainder on delivery. In the case ofinventory items, like frames, the expense is recognized when the items are sold to thecustomer — when the revenue is earned. Generally, the full amount will be recorded asanexpense when the invoice is received (assuming the goods or services have been provided).
With the cash-basis accountingmethod, a company records expenses when it actually pays suppliers. StyleVisionwould record the $500 down-payment on the frames when it places and pays for the order, andthen post the $500 balance when it receives the frames and issues that final payment.
A key metric for finance teams to track is days payable outstanding (DPO). Thisshows the average number of days it takes your company to make payments to creditors andsuppliers and indicates how well you’re managing both cash flow and supplierrelationships.
To calculate DPO, start with the average accounts payable for a given period, often a monthor quarter.
Average accounts payable = accountspayable balance at beginning of period - ending accounts payable balance/2
DPO = average accounts payable/cost ofgoods sold x number of days in the accounting period
What Is Accounts Receivable (AR)?
Accounts receivable arethe funds that customers owe your company for products or services that have been invoiced.The total value of all accounts receivable is listed on the balance sheet as current assetsand include invoices that clients owe for items or work performed for them on credit.
Generally, vendors bill their customers after providing services or products according toterms mutually agreed on when a contract is signed or a purchase order is issued. Termstypically range from net 30 — that is, customers agree to pay invoices within30 days — tonet 60 or even net 90, which a company may choose to accept to secure a contract. However,for large orders, a company may ask for a deposit up front, especially if the product ismade to order. Services firms also frequently bill some portion of their fees up front.
Once a company delivers goods or services to the client, the AR team invoices the customerand records the invoiced amount as an account receivable, noting the terms.
If the client pays as agreed, the team records the payment as a deposit; at that point, theaccount is no longer receivable. If the customer fails to pay on time, the AR or collectionsteam will likely send a dunning letter, which may include a copy of the original invoice andlist any late fees.
With accounting and finance software, companies can improve their days payables metrics byautomatically emailing customers about past-due invoices and requesting immediate payment.Business leaders can drill down into each account, or all past-due accounts, for moredetailed reporting on customer, invoice, due date, amount due and credit terms. Look for theability to exclude certain customers, such as those with extended terms, from collectionemails.
Accounts Receivable Example
Frames Inc. views StyleVision as a promising customer and is interested in growing therelationship. To win more business, Frames Inc. offers StyleVision net-60 with a 50%prepayment on new purchase orders of $1,000 or more. When StyleVision submits an order for$1,000, Frames Inc., which uses accrual accounting, records the full $1,000 as an asset inaccounts receivable when the order ships, expecting that the full invoice will be paid asagreed within 60 days after receipt of the frames.
How to Record Accounts Receivable
In accrual accounting, your receivable balance is listed in the general ledger under currentassets. When invoices are paid, finance credits the appropriate liabilities account anddebits accounts receivable to account for the payment. Applicable late fees would also beaccounted for as part of accounts receivable.
Several important ratios rely on accounts receivable, including:
Accounts receivable turnover ratio: Also known as the “receivableturnover”or “debtors turnover” ratio, the accounts receivable turnoverratio measures how efficiently and quickly a company converts its accountreceivables into cash within a given accounting period. The formula for calculating the ARturnover rate for a one-year period looks like this:
Net annual credit sales/average accounts receivables = Accounts receivables turnover
Current ratio: Also called working capital, this is a measure of liquidity—whether your company is able to pay short-term obligations with available cash or otherliquid assets that can be converted into cash within a year.
Working capital ratio = currentassets/current liabilities
Days sales outstanding (DSO): Shows how long, on average, it takes customersto pay your company for goods and services.
Days sales outstanding = accountsreceivable for a given period/total credit sales X number of days in the period
What Do Accounts Payable and Accounts Receivable Have in Common?
On the individual-transaction level, every invoice is payable to one partyand receivable to another party. Both AP and AR are recorded in a company’sgeneral ledger, one as a liability account and one as an asset account, and anoverview of both is required to gain a full picture of a company’s financial health.
CFOs need to pay equal attention to both payables and receivables. Resist seeing AP as simplya cost center. Areas to watch: Do both teams have the right tools, skills and capacity toscale with the business? Is the company extending, and receiving, the right amount ofcredit? Are benchmarks like days sales outstanding (DSO) trending in the right direction? Ifcash is tight, are suppliers being prioritized based on importance to the business,agreed-on terms and early-payment incentives?
For finance leaders, excellence in accounting practices, managing cash flow, producing betterreporting and maximizing working capital are top of mind, and both AR and AP are fundamentalto all of these.
Accounts Payable vs Accounts Receivable: Key Differences
For every sale or purchase, your business will either issue or receive an invoice. Ifyou’veprovided the good or service, the finance team will note the amount you expect to be paid inaccounts receivable. If you are paying the invoice, you’ll note the amount in accountspayable.
AR is considered an asset because you’re counting on receiving thatmoneywithin the timeline defined when the sale was initiated. AP is considered aliability because you will need to pay out that amount within a certaintimeline.
From a leadership perspective, these two functions need to remain strictly separate, in thehands of different departments or personnel. In fact, the American Institute of CPAsconsiders the segregation of duties a fundamental accounting principle and essentialinternal control for every business, primarily to reduce the risk of fraud.
In terms of accounts payable and accounts receivable, CFOs need to ensure that the personresponsible for paying bills cannot also enter invoices. In fact, some firms choose to haveone AR team member note receipt of customer payments and another post those payments to thegeneral ledger, and on the AP side, one team member may approve invoices and another triggerpayment.
Auditors use different methods to evaluate the efficacy of accounts payable and accountsreceivable safeguards. When auditors test AP, they typically look for instances of quantityerrors or, in some cases, unethical behavior on the part of the vendor. For example, thesupplier might have mistakenly, or purposely, billed for more products than it delivered.
For accounts receivable, auditors look at accounts that are past due beyond 120 days. At thatpoint, companies may need to adjust expectations. If leaders determine the clientcan’t orwon’t pay, finance needs to remove the amount from AR and charge it as an expense.
| Accounts Receivable | Accounts Payable |
|---|---|
| Money to be received | Money to be disbursed |
| Recorded as a current asset on the balance sheet | Recorded as a current liability on the balance sheet |
| Vendor’s record | Client’s record |
| Recognized as income unless written off | Recognized as a liability until paid |
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What’s the Relationship Between Accounts Payable and Accounts Receivable?
Accounts payable and accounts receivable are two sides of the same coin. How much do you owe,and how much is owed to you? This information helps you understand the financialstrength of your business and put in place practices togenerate a healthier cash flow.
A finance and accountingsolution helps businesses save time, improve control and increase productivity byautomating both invoice processing and payments. For example, the software can minimize thetime and effort required to process invoices by eliminating manual entry and automaticallycalculating discounts. It automatically handles exception processing when there aremismatches between invoices and purchase orders and provides real-time insights into theentire accounts payable process to reduce the potential for lost bills or fraudulent invoicepayments.
