Two of the most common business processes you will find yourself managing (if not obsessing over) in your accounting system are accounts payable and accounts receivable.
The concept is simple: accounts payable represents money you owe, while accounts receivable represents money you are owed.
But there’s more to it than that. Read this guide to understand the differences between the two accounts, how to record each of them, how they each impact your business, and strategies used to optimize them.
Understanding Accounts Payable and Accounts Receivable
Overview
| Accounts Payable (A/P) | Accounts Receivable (A/R) | |
|---|---|---|
| Brief Definition | Amounts owed to others by you | Amounts owed to you by others |
| What causes it? | Buying goods/services on credit from vendors or suppliers | Selling goods/services on credit to vendors or suppliers |
| Account type | Liability (current) | Asset (current) |
| General ledger effects | Debits an expense or asset account when generated, decreases cash when paid | Credits a revenue account when generated, increases cash when paid |
| Subledger | A/P subledger | A/R subledger |
Accounts Payable
Accounts payable (A/P) is the accounting term for money you owe to others for purchases you make on credit. They are current liabilities, meaning liabilities that are due within one year.
The journal entry is a credit to Accounts Payable (to increase it, since it’s a liability) and a debit an expense account. If you bought a capitalizable asset on credit, then an asset account would be debited instead.
Once you pay your bill, debit Accounts Payable (which clears out the payable) and credit Cash (to indicate that you’ve paid the payable).
Due to the high volume of payable and receivable transactions, payables and receivables get their own ledgers, called subledgers. Doing so makes recording and tracking these transactions much easier among the people you buy from and sell to. In most modern accounting systems, subledgers are seamlessly integrated into the General Ledger.
The general ledger pulls together the totals from each subledger. The general ledger then puts amounts into the proper asset, liability, and equity accounts.
While much of these procedures are automated, human error does happen. During your month-end closing, you will reconcile your subledgers with the general ledger to identify and correct any differences with correcting entries.
On the accounts payable side, you record transactions in the A/P subledger once you receive a bill or invoice from a supplier (or whoever you bought from). Part of the entry would involve tagging the correct supplier on the transactions.
For example, if you bought $100 of office supplies on credit from Vendor ABC, you would enter a $100 transaction for that Vendor ABC into your A/P subledger. This transaction would debit your office supplies expense account and credit accounts payable.
Accounts Payable vs. Notes Payable
Accounts payable are amounts owed for buying items on credit, whereas notes payable involve written promissory notes.
In other words, loans. In some cases — such as with expensive equipment purchases from vendors — you may record a note payable instead of an account payable.
Notes payable are generally long-term liabilities, as most loans or financing deals last longer than one year. However, you can have short-term notes payable — these are simply loans with a term length that is less than a year.
Accounts Receivable
Opposite of accounts payable is accounts receivable. These are amounts owed to you by your customers or clients for products/services they buy on credit.
When you make a sale on credit, you create a transaction in the A/R subledger. You also generate an invoice and send it to the client or customer, who must then pay it within the payment terms. Typical payment terms include 30 days — making accounts receivable a current asset.
In journal entry form, an accounts receivable transaction debits Accounts Receivable and credits a revenue account. When your customer pays their invoice, credit accounts receivable (to clear out the receivable) and debit cash (to recognize that you’ve received payment).
For example, if you sold $100 worth of products to Customer ABC, you would enter this $100 in the A/R subledger and tag Customer ABC.
Accounts Receivable vs. Notes Receivable
The difference between these two is the same as the difference between their payable counterparts. Accounts receivable are amounts owed to you for selling to clients/customers, whereas notes receivable are amounts owed to you that involve a promissory note.
You can have both short-term and long-term notes receivable, but accounts receivables are always short-term.
Accounts Payable, Accounts Receivable, and Working Capital
Working capital (also called net working capital) represents your operating liquidity — the total amount of assets you can quickly convert to cash should you need to. Having adequate working capital ensures you can cover short-term obligations.
Working capital is calculated by subtracting current liabilities from current assets.
Positive working capital means you can cover all your short-term obligations. However, excessive positive working capital could mean you are not effectively managing your assets. You may be failing to collect on your receivables in a timely fashion, or you could have extra cash that you could invest in your business for growth.
Likewise, negative working capital isn’t always bad. If your sales are through the roof, you will have to purchase large amounts of inventory — working capital may go negative temporarily.
Long-term negative working capital, however, is cause for concern. You may be struggling to stay afloat, relying on debt to fund everything. Or perhaps you’re doing fine, but you’re piling on more debt when you could be using cash.
Accounts payables and receivables likely make up the bulk of your current liabilities and assets, so effectively managing them is key to having sufficient working capital.
Days Sales Outstanding and Days Payable Outstanding
Analyzing your accounts receivable involves calculating your Days Sales Outstanding ratio, or DSO. This ratio represents the average amount of time it takes you to collect payment.
To calculate your DSO, divide your total accounts receivables by the total number of credit sales. Then, multiply the results by the number of days for the corresponding period (month, quarter, year, etc.).
As for payables, you would figure how long (on average) it takes you to pay an invoice by calculating your Days Payable Outstanding, or DSO.
Before calculating DSO, you need to know your cost of goods sold, or COGS. COGS is calculated by adding total inventory purchases to the amount of inventory you had at the beginning of the period, then subtracting your inventory amount at the end of the period.
You can also find this number on the income statement.
Then, divide your total accounts payable by COGS and multiply the result by the number of days.
Applying DSO and DPO
Increasing DPO and decreasing DSO both boost your working capital and can increase cash flows. However, they come at a cost.
If you increase DPO, you’re taking longer to pay your vendors. Yes, that means you hold on to cash longer and thus increase your working capital — but your vendors won’t like that.
A decrease in DSO might mean you’re giving stricter payment terms to customers or clients. Looser payment terms might reduce working capital, but it could bring you more business.
Recording and tracking your accounts payables and receivables add up to a lot of time each day — time you could be using to grow your business. If you’re interested in letting experts manage your A/P and A/R so you can do what you do best, contact CFO Hub today to schedule your free, no-obligation consultation.