Accounts Payable (Definition, Process)

What is Accounts Payable (AP)?

Accounts payable is the amount owed by the company to its supplier or vendors for purchasing goods or services and is usually shown as current liability on the balance sheet as these obligations are to be paid off by the company within a limited time period. It is important to know that accounts payable only exist in the case of accrual accounting and doesn’t exist in the cash accounting system.

In simple terms, Accounts Payable is money that needs to be paid to the Suppliers of raw materials, services to the company. We note from above, Wal-Mart AP has increased over the last 10 years, thereby resulting in days payable outstanding increase from approximately 36 days in 2010 to 40 days in 2016.

Explanation

Let’s say Company A produces shoes for men and women. And Company B supplies leathers to Company A. Now, Company A took $40,000 worth of supply from Company B on a credit that needs to be paid within a month. In this case, Company A, Company B is the creditor and the number of accounts payable is $40,000.

If we look at this situation from a different angle, we will see that to Company B, Company A is the debtor and the amount, $40,000 is accounts receivable.

From Walmart 2016 filing, we note that AP were $38,487 million in 2016 and 38,410 million in 2015.

source: Walmart 2016 10K Filings

As businesses are run on a large scale, not every purchase or sale can be in cash. So businessmen purchase or sell on credit to create more convenience for their partners in business. As a result, the concept of accounts payables and accounts receivables needs to be understood.

Under the accrual method of accounting, the receiver of goods or services on credit must report the liability immediately. Immediately means on the date when the goods or services were received.

Other than having accounting connotation, accounts payable is also considered as a process which reviews all account payables entries and whether they are rightly entered into the system or not.

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Under the accounts payable process, usually, the following information are reviewed –

Invoices from the company’s suppliers
Purchase orders sent by the company
Receiving reports sent by the company
Contracts and other agreements

Interpretation of Accounts Payable

First of all, as an investor, you are an outsider and you always don’t have a clue where the company stands. Irrespective of shiny financial statements, the actual position of the company hides which the investors need to discover. And that’s why days payable outstanding is so very important. By using the simple formula, the investor can find out after how many days the accounts payable was cleared. And if there is any delay, why.
Second, depending on the payment schedule; vendors decide the merit of the company. If a company pays the payable amount within the mutually decided period (i.e. 15 days, 30 days or 45 days), then the vendors look at them as esteemed customers. Otherwise, the vendor may change the terms and conditions of the contracts. Investors, by calculating DPO, can understand why certain agreements have been changed.
Thirdly, days payable outstanding helps the company strike a balance between paying too early and paying too late. Delaying the payment for a few days will be helpful for a company that needs to make the payment to the vendors. Because delaying the payment will enable the company to hold more cash. However, waiting too long for making the payment can also be critical for the relationship between the company and the vendors; because vendors may not too much delay in making the payment.

Examples of Accounts Payable

Mr. A has sources of raw materials from Mr. B for producing leather jackets and selling it to the end customers. We could only find the following information –

Total Purchase – $39,000

Cash Purchase – $15,000

Mr. B has mentioned that if Mr. A paid the invoice within 30 days of the transaction, he will be entitled to get another 2% discount on the total purchase.

So, what’s the amount to be paid if the actual payment is done within 30 days?

It’s a simple example. We just need to follow a step-by-step approach to find out how much needs to be paid.

The total purchase is $39,000.

A cash purchase is done in cash i.e. $15,000.

That means credit purchase would be = ($39,000 – $15,000) = $24,000.

As it is mentioned that the amount for credit purchase is paid within 30 days of the stipulated time, it’s assumed that a 2% discount on total purchase is also received.

So, the actual payment that needs to be made is = ($24,000 – $39,000*2%) = $23,220.

Accounts Payable Process

Accounts Payable process is important since it includes almost all the payment beyond the payroll. This process is usually handled by a separate department in large organizations. But in the case of small firms, the accounts payable process gets outsourced or handled by a book-keeper.

There are three things that are important in the account payable process –

The exact amount of quantity that the company has ordered (accuracy is the key).
What the company has actually received from the vendors.
Whether there is an issue in the calculation or not (for that account payable process examines the unit cost, terms & conditions, totals, and any other calculations).

One thing that ensures the smooth running of the accounts payable process is having internal control.

Having an internal control is beneficial to a company for the following reasons –

It catches up any fraudulent attempt to extract more money from the company than due.
It helps the company calculates the right amount to pay and not more or less.
It detects the possibility of getting invoiced twice or more and helps curb any additional expenses.
It also cross-checks the possibility of getting charged extra for the products that have been ordered.

That means, having your accounts payable process in place will help you curb the cost and excess payment; and will help you maintain enough free cash in the organization.

In the final analysis

Accounts Payable is an important concept in an organization if the organization follows an accrual method of accounting. In cash accounting, there is only cash inflow and cash outflow. Thus, there is no existence of accounts payable or accounts receivable.

As an investor, while understanding payable, you also need to make sure that you cross-check all these amounts with the vendors’ statement (if you can get your hands on them). In addition to accounts payable, you need to perform a comprehensive Financial Statement Analysis of the company to get the full picture.

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