Career Development

Accounts Payable (AP): Definition and How It Works

September 30, 2021

Understanding accounts payable (AP) is essential for anyone working with business finances or accounts. Managing accounts payable is a key part of successfully managing company cash flow and maintaining good business relations. In this article, we define accounts payable and discuss the accounts payable process.

What are accounts payable?

Accounts payable is what a company owes to suppliers or vendors for received goods or services. The term accounts payable refers to the individual balance sheet account that tracks the short-term debts for business goods and services bought on credit as well as to the business department responsible for repaying these short-term debts.

Related: Learn About Being an Accounts Payable Specialist

Steps in the accounts payable process

Following a clear and consistent accounts payable process helps businesses pay legitimate bills accurately and on time. This helps them manage their finances and maintain good business relationships. If you are an accounts payable department employee, a bookkeeper or a small business owner, you might take the following steps in the accounts payable process:

  1. Check invoice details.
  2. Enter invoice into accounting records.
  3. Schedule invoice payment.
  4. Mark invoice processed.
  5. Pay the invoice.
  6. Resolve accounting records.

1. Check invoice details

Some common details to look for on an invoice include:

  • Associated Purchase Order (PO): Internal company policy will determine which items absolutely require a PO and which items may not. Utility bills may not require a PO, but large, tangible items like office furniture, computers, phones or other items that need to be tracked usually will.

  • Date: If an invoice is dated in the future, then you should not pay it until the date listed. If it is unusually old, then you should research it to ensure it has not been paid previously. You should also contact the vendor or internal purchaser to note why the invoice was received so late.

  • Vendor: Some companies have an approved vendor list. Make sure it is a vendor you are authorized to pay. You also may require a W9 form for new vendors for tax purposes.

  • Description of services/product: Invoices should be itemized so that you can clearly see what you are paying for. Verify you got what you ordered.

  • Price: Make sure itemized costs add up to the total price. Be aware of purchasing limits. For instance, invoices over $1,000 may require additional approval. Tangible items over $10,000 may need to be capitalized as a fixed asset. Invoices over $25,000 may require board approval. Tax-exempt organizations should not pay sales tax.

  • Payment terms: Make sure you pay the invoice on time in order to avoid late fees. Some vendors offer discounts for paying early, so look for opportunities to save money.

  • Authorizing signature: Make sure someone has approved the invoice to pay. Internal policy may allow for certain invoices to be paid without prior approval—for instance, a blanket PO—so know your company’s policy.

2. Enter invoice into accounting records

Once you verify that the invoice is accurate and complete, enter the details as a credit into the accounts payable section of the company balance sheet. Most companies record the following information into their accounting software:

  • Invoice number
  • Invoice date
  • Vendor code or name
  • Amount credited to accounts payable
  • Amount and account(s) to be debited
  • Date of intended payment

Then enter the amount as a debit into the company's income statement. This double-entry practice maximizes the chances your company's financial records will be accurate and useful. If you are using accounting software, then the software will create these entries for you, but you will need to know the account codes for the debit transactions as you will be required to enter them into the accounting software.

3. Schedule invoice payment

Read the invoice terms carefully and schedule the invoice payment. The intended payment date will depend on the invoice terms and business' payment policies. Typically, businesses pay invoices as close to their due date as possible, as retaining funds for as long as possible improves cash flow. However, you might pay invoices early if suppliers offer early-payment discounts. Allow time for delivery if you are mailing the payment.

4. Mark invoice processed

Mark your invoice to show it has been entered into the accounts system. This step reduces the chance that duplicate account entries and payments will be made. Many companies use a stamp or perforation to show processing. Some staple the invoice, purchase order and receiving order together with a cover sheet called a voucher.

5. Pay the invoice

The invoice is then paid. This step often occurs automatically as businesses increasingly rely on automated payment methods. However, it may occur manually for businesses that prefer paying invoices with cash or checks.

6. Resolve accounting records

Once the payment is made, debit the amount from accounts payable and credit the amount to cash. If you are using accounting software, it should create these entries in the system automatically when a check run occurs. Businesses using a voucher system also move the voucher and its attached documents, including a copy of any checks issued, from an open file into a paid invoice file. Some businesses scan and electronically attach these records in their computer systems in order to minimize the storage of physical papers.

Differences between accounts payable and accounts receivable

Accounts payable is an account showing the amount a company owes third parties, while accounts receivable is an account showing the amount third parties owe the organization. While accounts payable is a current liability, accounts receivable is a current asset. Think of accounts payable and accounts receivable as the two opposite sides of a business transaction.

For example, Amy's Cleaning cleans the office of William's Mortgage Brokers. Amy's Cleaning issues William's Mortgage Brokers an invoice for the cleaning service. Amy's Cleaning records the invoice amount to their ledger with a credit to service revenue and a debit to accounts receivable. William's Mortgage Brokers records the purchase with a debit to an expense account and a credit to accounts payable. When William's Mortgage Brokers pays the invoice, it will debit accounts payable and credit cash. When Amy's Cleaning receives the payment, it will debit cash and credit accounts receivable.

Read more: 6 Essential Accounting Skills

Why are accounts payable important?

Accounts payable help businesses manage their cash flow and monitor their finances. Using accounts payable and purchasing goods and services on credit rather than making upfront payments lets businesses enjoy new assets while keeping funds in their accounts longer to earn more interest. Retaining funds longer can also help businesses spend more immediately to aid business growth.

Businesses can understand their spending habits by comparing their accounts payable figures from one fiscal year to the next. If the accounts payable amount increases, the business is buying more goods or services on credit. If the accounts payable amount decreases, the business is repaying prior debts faster than it is purchasing new goods or services on credit.

Read more: Q&A: What Does "Fiscal Year" Mean?

Tips for tracking accounts payable

These strategies can help you track accounts payable, especially when dealing with multiple suppliers and vendors:

  • Create a separate bills email account: A separate bills email account ensures all your digital invoices and accounts payable correspondence is in a single place for easier tracking. This will be useful if there is turnover in the accounts payable department.

  • Use separate in-trays: Separate in-trays for paper invoices, pending processing and pending payment helps you visually track which stage of the accounts payable process they are in. Once paper invoices are processed, move them to a separate folder in your filing cabinet. You may also like to print any digital invoices and use the in-trays to keep all your invoices together.

  • Perform accounts payable tasks regularly: Picking a regular time to perform accounts payable tasks, such as daily after lunch or every Friday afternoon, helps keep your duties on track and reduces the risk of losing documents. Choose an appropriate frequency for your business' number of credit transactions.

  • Use quality accounting software: A quality accounting system makes tracking and retrieving accounts payable details easy. These programs let you filter accounts payable by fields including invoice amount, issue date and other variables.

  • Communicate with purchasers: Accounts payable and purchasing are linked, but these functions should be separated to prevent fraud. If your business has a separate purchasing department, communicating with them regularly makes good business sense. Consult purchasing staff when you are paying large purchases or have questions about an invoice. If there is not a separate purchasing department, communicate regularly with the staff that makes or approves purchases.

Related: Accounts Payable vs. Accounts Receivable: What's the Difference?

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