Accounts Payable

The Accounts Payable function of an accounting system is responsible for tracking money the business owes and the payments made to those vendors. Our company’s Accounts Payable is also some other company’s Accounts Receivable.

We have seen examples of these entries throughout the book. In general, the entry is as shown as follows:

This creates the entry in which to record the debt we owe and records the expense in some expense account. Once we write the check, another entry credits the cash account and reduces the Accounts Payable balance.

Types of Payables

There are a variety of vendors, agencies, and banks, etc. to whom a business might owe money. Generally speaking, bills (i.e., payables) are organized into at least three categories of payables.

Trade Payables

Trade Payables are the bills that must be paid for purchases associated with running the business. This includes items such as shipping services, rent, office supplies, and utilities, etc. Almost every Trade Payable will have an associated expense account.

Taxes

Many government agencies expect businesses to collect taxes for them and to send these taxes to the agency periodically. Sales tax and payroll taxes are two common examples; the business is simply the middleman, obtaining the money for the tax (either from customers or from an employee’s gross pay, for example) and sending it to the government. Generally, the liability accounts are kept separate from regular trade payables.

Sales tax collected is not considered an expense of the business nor revenue of the business; it is simply a pass through. Similarly, the employee’s share of the taxes is not considered an expense (the payroll is, however), but simply a pass through to the tax agency. The company’s share of the taxes, however, is considered a business expense.

Loans and Notes

Loans and notes are legal agreements between the business and a financial institution (typically a bank) from whom the company has borrowed money (typically to purchase assets or to grow the business). For the most part, loans should not be used to pay Trade Payables because doing so raises concerns that the business is not generating enough income to pay its bills. Loans typically have a longer term than payables and are subject to interest payments to the bank. These interest payables are expenses to the business.

The journal entry made to borrow money from a bank might look like the following:

Expenses involved in setting up the loan are generally taken when the loan is first made, so cash is increased and the fee charged while the balance is placed into the payable account.

When periodic payments are made, the journal entry both reduces the notes payable account and records the interest expense, as shown below:

Amortization schedules are typically part of the loan documentation to let the business know how much interest needs to be paid as part of each payment on the loan.

Current Accounts Payable

Payables are broken into two sections: current liabilities and long-term liabilities. Trade Payables and taxes are almost always current liabilities. For the business to stay in business, it is expected that those obligations be paid timely from the revenue generated each period.

Long-term liabilities are typically your bank loans or notes or any other instrument where money is to be paid back in more than a year. Car loans and asset purchases, etc., are examples of these loans. However, for these types of loans, typically some portion of the loan is current. When the books are closed for the end of the period, a journal entry is prepared transferring the current portion from long-term liabilities to the current liabilities section. Your payable section might look this structure:

• Liabilities
• Current Liabilities

• Accounts Payable-Trade
• Accounts Payable-Misc.
• Taxes Payable

• Sales Tax
• Payroll Tax

• Current Portion of Long-term Debt
• Long-term Liabilities

• Loans Payable
• Notes Payable

The journal entry for our loan example (assuming a 10-year repayment) might look like this:

The payment would now be made against the 2500 account each month rather than against the Notes Payable account.

Trade Discounts

Just as a business might offer discounts for those who pay early, the vendors might also offer such discounts. You can then record your Accounts Payable gross (not recorded the discount unless actually taken) or net (assuming you will take the discount and only recording it when you don’t).

For example, let’s say a vendor offers 2%/10, net 30 (that’s a discount of two percent if paid within 10 days, otherwise the full amount is due in 30 days). Assuming we purchased $5,000 worth of goods, we can record the purchase and subsequent payment by using either method.

Net Method

Using the net method (where you assume the discount will be taken), the purchase entry is recorded at the discounted rate. The journal entry to record the purchase would appear as follows:

If payment is made on time, the following journal entry would record the payment:

However, if payment was not made within the discount window, you would need to record an additional expense to reflect the discount that was not taken. This entry would look like:

The benefit of this approach is that the accounting system clearly indicates the expense so management can decide whether or not to push to take discounts offered.

Gross Method

Using the gross method, you record the purchase entry under the assumption that you will not take the discount and only adjust the entry if you actually take the discount. The purchase entry is:

When the payment is made in 30 days for the full amount, the journal entry is:

However, if you pay within 10 days and take the discount, the entry becomes:

In this case, no one knows how many discounts were missed; only discounts that were actually taken are considered. One of the features of an accounting system is that procedures can be designed to present the appropriate information as needed by management. While investors might not care about that level of detail, managers who decide when to pay bills most likely do.

Summary

Accounts payable is concerned with how to keep track of the money you owe to various vendors and entities with whom you do business. The liabilities are generally categorized both by type and by current or long-term terms. You can also decide how you want to handle trade discounts, either by using the Gross method (which “hides” available discounts) or the Net method (which “shows” all of the discounts and clearly shows the missed discounts). If you see the missed discounts, it is easier to see where cash flow improvements might help the bottom line by reducing some of your costs.