Borrowing and lending is not a new idea. In fact, the concept of debt—of owing something to someone at a future date—predates even the existence of currency, with the oldest known recorded debt system dating to around 3500 BC. Under this system, Sumerian farmers would trade goods for goods, or, if they had no goods on hand, for the concept of goods to be delivered at a future date. In other words, they incurred debt.
In the modern business world, debts are recorded in an account known as accounts payable. Once the goods are delivered, you record the amount owed in accounts payable, where the sum remains until the debt is paid.
Tracking accounts payable is critical to evaluating a company’s current financial status. It also helps with managing cash flows, meeting deadlines with vendors, ensuring the accuracy of financial statements, identifying and eliminating unnecessary expenses, and planning for long-term business growth.
What is accounts payable (AP)?
Accounts payable (AP) is an account that represents a company’s short-term debts. Essentially, this number represents all the money a business owes others. This account is listed on a balance sheet, which is a key financial statement and part of a company’s general ledger.
Accounts payable includes utilities and facility costs, rents, licenses, outstanding vendor or contractor invoices, and other monthly expenses. AP is also used as shorthand to refer to a company’s accounts payable department, which is the person or department responsible for managing all of a company’s outstanding financial obligations, recording them on the balance sheet under accounts payable, and processing payments.
How does an accounts payable process work?
Managing accounts payable works as follows:
- Your company submits a purchase order or signs a contract with a vendor.
- Goods or services are delivered, and the vendor submits an invoice to the accounts payable department.
- The AP department records the sum of the vendor invoice as a credit to accounts payable.
- The AP department requests approval to pay the invoice from the business owner, CFO, or another party authorized to approve expenses.
- Once approval is received, the department processes payment for the invoice and debits accounts payable for the amount of the payment.
It’s important to note that accounts payable quantifies total short-term debt by representing liabilities as a positive number. This explains why accounts payable is credited (instead of debited) when a vendor invoice is received. An accounts payable balance of $5,000 means that your company owes $5,000 to its creditors. A negative balance is unusual and would mean that your company overpaid for a good or service and is owed money in return.
Accounts payable automation software
Managing the AP process can be made easier by using accounts payable automation software. This software uses automatic invoice processing technology to read and digitize vendor invoices, match invoices with purchase orders, and credit the appropriate amount to accounts payable. AP automation eliminates the need for you or a member of your team to devote time to this task and reduces the potential for human error. When approval is received and payment is made, this software will automatically debit accounts payable, keeping your balance sheet organized and up to date.
AP automation software can also generate other financial statements, including income statements and cash flow statements. Together, these statements provide a record of the movement of funds through your business: the balance sheet provides a snapshot of your current financial state, the income statement (also known as a profit & loss statement) shows gains or losses over a period of time, and the cash flow statement catalogs how money entered and left the business during that period.
Accounts payable vs. accounts receivable
Under an accrual accounting method, accounts payable is used in tandem with accounts receivable to help businesses manage cash flows and provide a clear picture of a company’s overall liquidity.
While accounts payable tracks the money that your business owes, accounts receivable tracks the money that your business is owed by clients or by other debtors. Both accounts are tracked on a company’s balance sheet. Accounts receivable records purchases made by extending credit to customers up until the time that payment is received. Once payment is received, your accounting team will debit accounts receivable for the payment amount and apply the credit to your revenue account.
Accounts payable vs. trade payables
Although the terms are sometimes interchanged, accounts payable is not the same as trade payables. Trade payables represent goods and inventory—say, the fabric that you use to sew a quilt or the toner for your office printer. Accounts payable, on the other hand, is an umbrella term referring to all of a company’s outstanding debts. Rent, utility fees, software licenses, and membership in professional organizations are examples of expenses that fall under accounts payable but not under trade payables.
Think of these as nested accounts—total accounts payable includes all outstanding obligations to other companies while trade payables represents the subset of accounts payable that is due in exchange for inventory items.
There are a number of benefits to tracking accounts payable. Knowing how much money you owe (and when you owe it) helps business owners manage cash flow and plan to meet all outstanding obligations. Your AP department (or accounts payable automation software) can also time the payment of debts strategically, allowing you to operate with less cash on hand in times when doing so is advisable for tax or business-related reasons.