Accounts receivable and accounts payable are the yin and yang of business: When revenues and expenditures stay in healthy equilibrium, the company can seize growth opportunities, and relationships with customers and suppliers remain on a positive footing.
A company’s accounts payable (AP) ledger lists its short-term liabilities — 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 and partners. 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 financial health. 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 payables comprise amounts it owes to suppliers and other creditors — items or services purchased and invoiced 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 terms both parties agreed to when initiating the transaction. When a finance team receives a valid bill for goods and services, it is recorded as a journal entry and posted to the general ledger as an expense. The balance sheet shows the total amount of accounts payable, but it does not list individual transactions.
Once an authorized approver signs off on the expense and payment is issued per the terms of the contract, such as net-30 or net-60 days, the accounting team records the expense as paid.
AP departments are responsible for processing expense reports and invoices and for ensuring payments are made. A skilled AP team keeps supplier relationships positive by making sure vendor information is accurate and up-to-date and bills are paid on time. The team can save the company money by taking full advantage of favorable payment terms and available discounts. A strong AP practice contributes to business success by ensuring cash forecasts stay accurate, minimizing mistakes and fraud and generating reports for business leaders and third parties.
Say on-trend eyewear maker StyleVision orders $500 worth of new frames from its wholesale supplier, Frames Inc., which sends the invoice on Aug. 15 with net-30 terms and no discount for early payment. StyleVision’s bookkeeper creates an accounts payable journal entry and credits Frames Inc.’s account $500 by Sept. 15, then debits $500 from StyleVision’s inventory 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. For instance, 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 of inventory items, like frames, the expense is recognized when the items are sold to the customer — when the revenue is earned. Generally, the full amount will be recorded as an expense when the invoice is received (assuming the goods or services have been provided).
With the cash-basis accounting method, a company records expenses when it actually pays suppliers. StyleVision would record the $500 down-payment on the frames when it places and pays for the order, and then 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). This shows the average number of days it takes your company to make payments to creditors and suppliers and indicates how well you’re managing both cash flow and supplier relationships.
To calculate DPO, start with the average accounts payable for a given period, often a month or quarter.
Average accounts payable = accounts payable balance at beginning of period - ending accounts payable balance/2
DPO = average accounts payable/cost of goods sold x number of days in the accounting period
What Is Accounts Receivable (AR)?
Accounts receivable are the 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 assets and 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 to terms mutually agreed on when a contract is signed or a purchase order is issued. Terms typically range from net 30 — that is, customers agree to pay invoices within 30 days — to net 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 is made 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 customer and 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, the account is no longer receivable. If the customer fails to pay on time, the AR or collections team will likely send a dunning letter, which may include a copy of the original invoice and list any late fees.
With accounting and finance software, companies can improve their days payables metrics by automatically emailing customers about past-due invoices and requesting immediate payment. Business leaders can drill down into each account, or all past-due accounts, for more detailed reporting on customer, invoice, due date, amount due and credit terms. Look for the ability to exclude certain customers, such as those with extended terms, from collection emails.
Frames Inc. views StyleVision as a promising customer and is interested in growing the relationship. 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 in accounts receivable when the order ships, expecting that the full invoice will be paid as agreed 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 current assets. When invoices are paid, finance credits the appropriate liabilities account and debits accounts receivable to account for the payment. Applicable late fees would also be accounted for as part of accounts receivable.
Several important ratios rely on accounts receivable, including:
Accounts receivable turnover ratio: Also known as the “receivable turnover” or “debtors turnover” ratio, the accounts receivable turnover ratio measures how efficiently and quickly a company converts its account receivables into cash within a given accounting period. The formula for calculating the AR turnover 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 other liquid assets that can be converted into cash within a year.
Working capital ratio = current assets/current liabilities
Days sales outstanding (DSO): Shows how long, on average, it takes customers to pay your company for goods and services.
Days sales outstanding = accounts receivable 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 party and receivable to another party. Both AP and AR are recorded in a company’s general ledger, one as a liability account and one as an asset account, and an overview 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 simply a cost center. Areas to watch: Do both teams have the right tools, skills and capacity to scale with the business? Is the company extending, and receiving, the right amount of credit? Are benchmarks like days sales outstanding (DSO) trending in the right direction? If cash 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 better reporting and maximizing working capital are top of mind, and both AR and AP are fundamental to all of these.
Accounts Payable vs Accounts Receivable: Key Differences
For every sale or purchase, your business will either issue or receive an invoice. If you’ve provided the good or service, the finance team will note the amount you expect to be paid in accounts receivable. If you are paying the invoice, you’ll note the amount in accounts payable.
AR is considered an asset because you’re counting on receiving that money within the timeline defined when the sale was initiated. AP is considered a liability because you will need to pay out that amount within a certain timeline.
From a leadership perspective, these two functions need to remain strictly separate, in the hands of different departments or personnel. In fact, the American Institute of CPAs considers the segregation of duties a fundamental accounting principle and essential internal 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 person responsible for paying bills cannot also enter invoices. In fact, some firms choose to have one AR team member note receipt of customer payments and another post those payments to the general ledger, and on the AP side, one team member may approve invoices and another trigger payment.
Auditors use different methods to evaluate the efficacy of accounts payable and accounts receivable safeguards. When auditors test AP, they typically look for instances of quantity errors or, in some cases, unethical behavior on the part of the vendor. For example, the supplier 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 that point, companies may need to adjust expectations. If leaders determine the client can’t or won’t pay, finance needs to remove the amount from AR and charge it as an expense.
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 financial strength of your business and put in place practices to generate a healthier cash flow.
A finance and accounting solution helps businesses save time, improve control and increase productivity by automating both invoice processing and payments. For example, the software can minimize the time and effort required to process invoices by eliminating manual entry and automatically calculating discounts. It automatically handles exception processing when there are mismatches between invoices and purchase orders and provides real-time insights into the entire accounts payable process to reduce the potential for lost bills or fraudulent invoice payments.