Paying equal attention to accounts payable and receivable is the key to a smooth running business, but you should also treat them separately. Because once you have control over both sets of processes, you’ll be able to maintain a stable business and be ready for growth opportunities.
In this article, we explain the basics, so you know the difference between these terms and understand why they’re both important to the health of your business.
What is accounts payable?
Accounts Payable, also known as AP, is a general ledger account sitting in the current liabilities section of your company’s balance sheet. This account lists the company’s current obligations to pay suppliers or creditors. Essentially, it’s money you owe to third parties. A current liability is defined as an amount due to creditors within 12 months.
The accounts payable department’s role is to provide administrative and financial support to your business and manage all invoices it receives. It involves approving, processing, and payment and reconciliation of creditor invoices.
A well-managed accounts payable department streamlines the payment process and saves your business considerable time and money. The team controls outgoing cash by deciding when to pay invoices — to capitalize on early payment discounts and avoid late fees, as well as how to pay (via check or electronically).
What is accounts receivable?
Accounts Receivable, or AR, is a general ledger account sitting in the current assets section of the company’s balance sheet. The balance refers to outstanding sales invoices issued by the company to customers. It’s considered an asset because the company has extended lines of credit to customers that are expected to be received within the collection terms (usually 30 or 60 days). A current asset is expected to be converted to cash within 12 months.
The accounts receivable department manages the entire process from invoice creation to money collection, including following up late paying customers about overdue invoices and requesting immediate payment. The goal is to collect this money as fast as possible, to free up cash flow for use in the business.
The list of accounts receivable invoices is often sorted into an ‘aged debtors’ report to analyze the amounts according to the number of days past due date. A provision for doubtful debts is a journal entry posted by accountants to estimate an amount of the balance that will not be collected. This provision offsets the accounts receivable account balance.
By recording a doubtful debts provision, you can account for the impact of bad debts earlier than if you waited months to find out which invoices are uncollectible.
What does each department have in common?
In every business transaction, the invoice raised is both a payable to one party and a receivable to another party.
Accurate reporting of accounts payable and receivable is vital for all businesses using the accrual accounting method. This is when transactions are recorded as revenue and expenses on the income statement in the period the transaction occurs, rather than waiting until the cash is received or paid (which is the cash accounting method).
So, it’s important both payable and receivable accounts are updated regularly to ensure the income statement is a true reflection of money earned and spent by your business.
Differences between accounts payable vs. accounts receivable
The main difference to your business is the accounts payable balance is money your business owes and the accounts receivable is money it is owed.
In terms of business structuring, the two functions need to be separated for internal control purposes and to reduce the risk of fraud, so you need to a dedicated department/personnel for each. This means those responsible for raising invoices shouldn’t also have the authorization to pay them.
How do I record both sets of accounts?
When the accounts payable department or personnel receives a supplier invoice, a journal entry is recorded in the accounting system and the expense is posted to the general ledger. The unpaid amount is added to the accounts payable balance, which will be cleared once payment is made out of the business bank account.
When a sale is made, the accounts receivable department records a journal entry to account for the income, and adds the amount to the accounts receivable balance. A sales invoice is created and sent to the customer (usually electronically) detailing the amount to be paid and the collection terms.
Once it is deposited into the business bank account, the AR personnel match the receipt to the relevant invoice, marking the invoice as paid and recording a journal entry to clear the accounts receivable account balance.
Optimizing these processes helps your business maintain a healthy cash flow, so you have a steady stream of incoming cash to cover all day-to-day expenses.
To streamline both functions, create a clear step-by-step process for teams to follow, with the aim of preventing invoices from getting lost or sent to the wrong people, and reducing inaccurate information on them.
Good news: you can automate most of your accounts receivable process with cloud accounting software, so the invoices are raised and sent for you,
removing manual data entry and human error. Accounting software supports the collection process too by automatically emailing customers about past-due invoices. You can also negotiate favorable payment terms with your suppliers, allowing you to free up more cash.
Examples of payable and receivable accounts
Accounts payable accounts have all the amounts in the general ledger your business owes to suppliers, such as for materials, equipment, transport, energy, and services like subcontracting. It does not include other types of current liabilities like payroll, taxes, accruals or short term portions of debt which are recorded separately.
Accounts receivable accounts are made up of all the invoices that have been sent to customers or clients for items sold or services performed for them on credit. It doesn’t include other types of current assets like cash, inventory, or prepaid expenses.
Cash is so important in small business, and now that you understand the fundamentals of accounts receivable and accounts payable, you’re in a great place to optimize your business processes and maintain a healthy cash flow.