Accounts payable and accounts receivable essentially represent money you owe and money owed to you.
Accounts payable and accounts receivable are recorded on your asset and liquidity accounts, respectively, and can provide a snapshot into the liquidity and financial health of your business.
Ideally, you will be able to maintain a healthy balance between these figures so that you know you have enough cash coming in to meet your debt obligations, invest in growth, and maintain good relationships with both customers and suppliers.
In this article, we explain the difference between accounts payable and accounts receivable, how to record them properly in your company ledger, and best practices for accounts payable and receivable.
Accounts payable is a current liability account that represents the amount you owe to your creditors and suppliers. In other words, it is a record of any money you owe to third parties.
Accounts payable does not include ongoing liabilities like staff wages or rent or long term debt like your mortgage.
Whenever you receive an invoice from a supplier for goods or services rendered, you should record the amount in your general ledger as a liability. The invoice will usually stipulate payment terms, giving you between 30 and 90 days to settle the debt. The accounts team is then responsible for paying the supplier according to the invoice terms and recording the expense as paid.
An Ecommerce fashion retailer places an order for 100 t-shirts from its wholesale supplier at a cost of $5 per t-shirt. The supplier ships the bulk order and issues an invoice to the retailer for $500 with 30-day payment terms.
Once the ecommerce company has received the order, its accounting team will create an accounts payable entry for $500 in its general ledger. This expense should be listed in accounts payable until the invoice is settled.
Accounts receivable refers to any outstanding amounts that are owed to you by third parties. For example, any invoices for goods or services that you’ve supplied to clients or customers that have yet to be paid for. Accounts receivable are recorded on your ledger as a current asset.
You can use accounts receivable to keep track of all payments due to your business from third parties. By recording these amounts in your ledger, you can see which invoices have been settled and which might need to be chased.
We can flip the above example to understand accounts receivable. When the wholesale supplier has shipped the order of 100 t-shirts to the ecommerce fashion retailer, it will record a balance of $500 in accounts receivable until the client has settled the invoice.
The key differences between accounts payable and receivable are:
Liabilities and assets, inflows and outflows - accounts payable and receivable are binary everyday accounting principles that are relatively easy to get to grips with. So why do they matter so much?
Most importantly, accounts payable and receivable provide a snapshot of the financial health of your business. They allow you to understand, in an instant, whether or not you have enough money coming in to settle your debts or to afford any other time-sensitive expenses. If you can see ahead of time that you’re going to have cash flow issues, you can take action to mitigate the impact on your business.
Ideally, you will be able to optimize your accounts and improve your cash flow. But if this isn’t possible, you could scale back or delay growth plans, or you could reach out to a supplier to extend your payment terms. That way you won’t risk getting into further debt or damaging important relationships.
You should follow Generally Accepted Accounting Principles (GAAP) when you record both accounts payable and receivable. That means using the double-entry, accrual-based accounting method to ensure that your accounts are accurate, transparent, and compliant.
Let’s return to the example of the Ecommerce fashion retailer. Once the retailer has received the shipment of 100 t-shirts, it records the $500 as an accounts payable liability on the company balance sheet and as an expense on its income statement. It then lists the t-shirts for sale on its website for $10 each.
At the same time, when the wholesaler has shipped the order and issued the invoice, it records $500 under current assets in accounts receivable.
Once the retailer has sold the t-shirts to the end customer, it can use this cash to settle the invoice. It then deducts the $500 from accounts payable and recognizes each $10 t-shirt sale as earned revenue on its income statement.
Now the invoice has been settled, the wholesaler credits its liabilities account and debits accounts receivable to recognize the payment. If the retailer is late settling the invoice, any fees it pays as a penalty should also be accounted for.
In some cases, the retailer might make a prepayment of, for example, 50% on the $500 purchase order. The wholesaler would still record the $500 as an asset in accounts receivable until the amount has been paid in full.
The best way to avoid cash flow issues is to optimize your accounting process. Here are our three best practices for accounts payable and receivable:
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