What is accounts payable and accounts receivable

If you’re a new business owner, you may not be familiar with accounts payable and accounts receivable, but both play a crucial role in your day-to-day business operations. 

Accounts receivable is the money your company brings in from the sale of its products and services. In contrast, accounts payable is the money your business owes its suppliers and vendors. 

This article will explain more about how each one works, how they affect your business and how to accurately track this financial data. 

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Accounts payable vs. accounts receivable

Understanding the difference between accounts payable and accounts receivable will help you better grasp accounting processes. If you confuse the two, you could end up with an incorrect balance in your general ledger.

Accounts payable refers to money your company owes to its supplier, while accounts receivable refers to the money customers owe your business. Accounts receivable is considered an asset in accounting, since it generates cash flow for your organization. Accounts receivable will typically turn over to cash within a year. 

In comparison, accounts payable is a liability, since it’s money your business owes. These differences are highlighted in the table below.

What are accounts payable?

It’s essential to stay on top of your accounts payable. Knowing how much your company owes will help you avoid late payments and additional fees. 

Accounts payables are short-term debts owed to your suppliers and vendors, so they’re usually seen as liabilities. Here are some examples of accounts payable transactions:

• The purchase of goods or services from another company
• A loan from a bank or financial institution
• The purchase of raw materials
• Travel expenses
• Equipment
• Leasing
• Transportation

These are different types of accounts payables: 

• Taxes
• Wages payable
• Loans payable
• Nontrade payables
• Trade payables 

All of these items – except for wages payable – are processed through the accounts payable system. Wages payable is processed when your company runs payroll. 

When recording an accounts payable transaction, you want to debit the expense from your account. For instance, if your business purchases $500 in office supplies from Staples, your general ledger should show the debit from your accounts payable. 

Here is an example of how that transaction would look:

What are accounts receivable?

Accounts receivable is money owed to your business by your customers. Since accounts receivable payments generate future cash flow for your company, it’s considered an asset. Managing accounts receivable means becoming an efficient debt collector.

Examples of accounts receivable include a phone company billing a customer for their monthly cell phone usage. While waiting for the customer to pay the bill, the accounting department would mark it as an unpaid invoice on their accounts receivable. Any goods sold or service rendered is considered to be accounts receivable. 

It’s your company’s responsibility to bill your patrons for any services rendered. Your invoice will include the product or service rendered, the payment amount, sales tax and the due date. 

To record accounts receivable, you must first ensure the debit is receivable and then credit the revenue account. When the customer pays their invoice for services rendered, your business will debit the cash amount and credit the accounts receivable account. 

If the invoice is for product sales, you’ll want to add an inventory reduction on your balance sheet. For example, if your company finalizes a sale of $30,000, and $15,000 was from the sale of products, here’s how you would record that information in your general ledger: 

Finally, it’s essential to establish a credit approval process for your customers. This process includes creating a credit application and credit terms. 

Discounts on accounts payable and receivable

There are many advantages to paying an account before it’s past due. Some vendors will be willing to offer you a discount for paying your invoice within 10 to 14 days of the initial due date. 

If a vendor offers an early payment discount, your business will save money by paying early. And the vendor benefits by receiving the payment ahead of time and having additional access to cash flow. 

While a minor discount may not seem like a big deal, it can significantly improve the profits of your company. Even receiving a 2% discount can improve yields in the long term. 

If you receive an early payment discount, you should note the discount in the ledger to avoid any future discrepancies. For example, let’s say your business offers a 10% discount if the invoice is paid at least a week early. 

In this case, the journal entry would read as follows:

Finally, there are usually guidelines on how to track the discount being offered. For example, if you pay the invoice within 10 days for a 4% discount, the notation on the invoice should read 4/10. Both numbers can change depending on the exact discount and the due date to receive the discount. 

Tracking accounts payable and receivable

To track accounts payable and receivable, hold on to every receipt, invoice and order. If even one invoice slips under the cracks, your financial records will be off balance. 

Tracking your financial accounts properly from the beginning will help your business succeed in the long run. Additionally, it will show your customers that you operate your business in a professional manner. 

You also must stay current of due dates for both customers and vendors. Managing the money you owe and the money owed to you will ensure you receive and make your payments on time. 

It’s also a good idea to keep an eye on any aging accounts. These are accounts that weren’t paid on time that can be overlooked. 

How accounting software can help 

It’s beneficial to invest in feature-rich accounting software to help you manage both accounts payable and receivable. Here are a few benefits of investing in accounting software:

• It reduces errors. Software programs can reduce errors by removing manual data entry. 
• You can set up invoices. Use accounting software to set up recurring invoices and track customer information. 
  
• You can track vendor payments. You can use accounting software to manage vendor payments and ensure you don’t miss a due date. 
  
• You can run reports. You can also use accounting software to run daily and monthly reports – such as a profit and loss statement, balance sheet, or cash flow statement. 

Accounting software will save you valuable time by doing some of the more tedious work for you. The software you use will depend on the type of business you run, and most software programs can be customized to fit your specific needs. 

Proper accounting minimizes errors

Accounts payable and accounts receivable are necessary to ensure you’re accurately tracking your cash flow and spending. Understanding the difference is important so you don’t accidentally mix up the two in your general ledger. 

When your business correctly tracks its accounts payable and receivable, there is a higher likelihood that it won’t run into any errors. This accuracy is vital if you don’t have a large accounting department managing your firm’s financial information.

Finally, it’s a good idea to use accounting software to log and track your company’s financial information. The right software will save you valuable time and money, and help prevent errors that could hurt your bottom line in the long run. 

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What is accounts payable in simple words?

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