What are accounts payable? The business owner’s basic guide
There are few things more exciting in life than starting a new business and realizing your long-time dream. But along with the dream comes the accounting aspect of your enterprise. While it’s not as glamorous, it’s still an important part of running a successful business.
Whether you own a coffee shop or you’re an independent interior designer, you should know accounting basics. It will help you get a better financial understanding, maintain profitability, and be better prepared for tax season.
In this article, we’ll introduce you to the basics of accounts payable: what they are, how to manage them, and how to pay them.
What are accounts payable?
Accounts payable (sometimes referred to as “AP” or “A/P”) are the total amount of short-term debt your business owes to creditors, vendors, and suppliers for services or goods you purchased but have not paid for yet.
If you’re buying materials for your small business, leasing a van, or subcontracting a carpenter to build a desk for you, the payments due for these goods and services are all considered accounts payable.
It’s extremely important to know how much money your business owes and when payment is due. This ensures you maintain proper cash flow and avoid getting into debt or late payments.
In business-to-business transactions, getting the merch and paying for it don’t necessarily coincide. Typically, when you buy goods or services, the payment is not made on the spot.
Your vendor will give you a certain period of time to pay – commonly 30 days from the date of the invoice. It’s called “Net [number of days to pay]”, so when the payment terms are “net 30”, your vendor wants to be paid within 30 days of the invoice date.
Let’s take an example: say you own a barbershop, and you place an order for ten cases of hair spray bottles from your supplier, for a total of $1,000.
You receive the goods, along with an invoice specifying the amount, type and quantity of the goods provided, and the payment terms (net 30). This means that:
- The amount of $1,000 is added to your accounts payable.
- You need to make the payment within 30 days from the date of the invoice.
- Once payment has been made, the debt is removed from your accounts payable balance.
How are accounts payable related to accounts receivable?
Accounts receivable are the “other side of the coin” for the vendor or supplier that the debt is owed to. When a business provides goods or services to another business, the expected payment for them is registered as accounts receivable, until it’s collected in full. So, for your business, accounts receivable include the money that business clients owe you as their vendor.
Is accounts payable just another name for “expenses”?
Accounts payable and expenses are two different accounting terms representing two aspects in a business’s financial statements. There are three main differences between accounts payable and expenses.
It should be noted that the two terms can represent the same transaction in certain circumstances. For example: if you purchase goods from a vendor, they are accounted as part of your accounts payable until you pay for them. After you’ve paid, they will be registered as an expense.
How does the accounts payable process work?
There are three steps to process accounts payable:
- Review the bill.
Check that everything is in place: does it correspond to the type and amount of goods or services ordered? Were the goods or services received in full? Are the calculations correct?
You can use the 3-way match method to ensure there are no discrepancies between the order, invoice, and payment: in this method, you compare three documents – the invoice, purchase order, and receiving report – to ensure their details match.
- Record the bill in your books.
Add the bill into your accounting software or your bill pay service. Make sure the details (amount, date, vendor name, etc.) are correct. Whether you’re using QuickBooks Online, FreshBooks or another accounting software, once you add the bill to your account, it updates your accounts payable accordingly.
- Pay the bill on time.
When we say on time, it does not mean before its time. The early bird here does not get the worm. It means paying the bill as close as reasonably possible to its due date, without risking late payment.
Why? Cash flow. Your business’s lifeline depends on its ability to hold on to its cash reserves as long as possible. If you’re not getting an early payment discount on your bill, there’s no reason to pay it before it’s due.
Now here’s the tricky part. If you’re paying bills manually (by check or cash) or your payment method isn’t synced with your accounting software, things get more complicated. That’s because you have to manually update your accounting software after you pay the bill. If you forget to do so or make a mistake, your accounts payable will not reflect the reality of the money your business owes.
What’s more, you won’t be able to schedule the payment so it’s paid on time, but not too early (cash flow – remember?).
That’s why we recommend you use a trusted online bill pay service that enables you to add bills, upload invoices, and schedule payments ahead of time. It’s also important that your bill pay service syncs with your accounting software, so when you add or pay a bill, it automatically reflects your accounts payable, without you having to update it manually.
You could be the savviest entrepreneur and business owner, have an out-of-this-world product, and killer marketing. Odds are, it still won’t be enough for your business to succeed, if you don’t have a firm grasp on your accounting.
Understanding what accounts payable are, how they impact your business, and how to manage them properly is key to the success of your business. That’s why it’s important you dedicate the time to master it (as well as other essential accounting terms).