Accounts payable (AP), or “payables,” refer to a company’s short-term obligations owed to its creditors or suppliers, which have not yet been paid. Payables appear on a company’s balance sheet as a current liability.
Another, less common usage of “AP,” refers to the business department or division that is responsible for making payments owed by the company to suppliers and other creditors.
Accounts payable can be compared with accounts receivable.
Key Takeaways
Accounts payable (AP) are amounts due to vendors or suppliers for goods or services received that have not yet been paid for.
The sum of all outstanding amounts owed to vendors is shown as the accounts payable balance on the company’s balance sheet.
The increase or decrease in total AP from the prior period appears on the cash flow statement.
Management may choose to pay its outstanding bills as close to their due dates as possible in order to improve cash flow.
Understanding Accounts Payable (AP)
A company’s total accounts payable balance at a specific point in time will appear on its balance sheet under the current liabilities section. Accounts payable are obligations that must be paid off within a given period to avoid default. At the corporate level, AP refers to short-term payments due to suppliers. The payable is essentially a short-term IOU from one business to another business or entity. The other party would record the transaction as an increase to its accounts receivable in the same amount.
AP is an important figure in a company’s balance sheet. If AP increases over a prior period, that means the company is buying more goods or services on credit, rather than paying cash. If a company’s AP decreases, it means the company is paying on its prior period obligations at a faster rate than it is purchasing new items on credit. Accounts payable management is critical in managing a business’s cash flow.
When using the indirect method to prepare the cash flow statement, the net increase or decrease in AP from the prior period appears in the top section, the cash flow from operating activities. Management can use AP to manipulate the company’s cash flow to a certain extent. For example, if management wants to increase cash reserves for a certain period, they can extend the time the business takes to pay all outstanding accounts in AP.
However, this flexibility to pay later must be weighed against the ongoing relationships the company has with its vendors. It’s always good business practice to pay bills by their due dates.
Recording Accounts Payable
Proper double-entry bookkeeping requires that there must always be an offsetting debit and credit for all entries made into the general ledger. To record accounts payable, the accountant credits accounts payable when the bill or invoice is received. The debit offset for this entry generally goes to an expense account for the good or service that was purchased on credit. The debit could also be to an asset account if the item purchased was a capitalizable asset. When the bill is paid, the accountant debits accounts payable to decrease the liability balance. The offsetting credit is made to the cash account, which also decreases the cash balance.
For example, imagine a business gets a $500 invoice for office supplies. When the AP department receives the invoice, it records a $500 credit in accounts payable and a $500 debit to office supply expense. The $500 debit to office supply expense flows through to the income statement at this point, so the company has recorded the purchase transaction even though cash has not been paid out. This is in line with accrual accounting, where expenses are recognized when incurred rather than when cash changes hands. The company then pays the bill, and the accountant enters a $500 credit to the cash account and a debit for $500 to accounts payable.
A company may have many open payments due to vendors at any one time. All outstanding payments due to vendors are recorded in accounts payable. As a result, if anyone looks at the balance in accounts payable, they will see the total amount the business owes all of its vendors and short-term lenders. This total amount appears on the balance sheet. For example, if the business above also received an invoice for lawn care services in the amount of $50, the total of both entries in accounts payable would equal $550 prior to the company paying off those obligations.
Accounts Payable vs. Trade Payables
Although some people use the phrases “accounts payable” and “trade payables” interchangeably, the phrases refer to similar but slightly different situations. Trade payables constitute the money a company owes its vendors for inventory-related goods, such as business supplies or materials that are part of the inventory. Accounts payable include all of the company’s short-term obligations.
For example, if a restaurant owes money to a food or beverage company, those items are part of the inventory, and thus part of its trade payables. Meanwhile, obligations to other companies, such as the company that cleans the restaurant’s staff uniforms, fall into the accounts payable category. Both of these categories fall under the broader accounts payable category, and many companies combine both under the term accounts payable.
Accounts Payable vs. Accounts Receivable
Accounts receivable (AR) and accounts payable are essentially opposites. Accounts payable is the money a company owes its vendors, while accounts receivable is the money that is owed to the company, typically by customers. When one company transacts with another on credit, one will record an entry to accounts payable on their books while the other records an entry to accounts receivable.
What Are Some Examples of Payables?
A payable is created any time money is owed by a firm for services rendered or products provided that has not yet been paid for by the firm. This can be from a purchase from a vendor on credit, or a subscription or installment payment that is due after goods or services have been received.
Where Do I Find a Company’s Accounts Payable?
Accounts payable are found on a firm’s balance sheet, and since they represent funds owed to others they are booked as a current liability.
How Are Payables Different From Accounts Receivable?
Receivables represent funds owed to the firm for services rendered and are booked as an asset. Accounts payable, on the other hand, represent funds that the firm owes to others. For example, payments due to suppliers or creditors. Payables are booked as liabilities.
Are Accounts Payable Business Expenses?
No. Some people mistakenly believe that accounts payable refer to the routine expenses of a company’s core operations, however, that is an incorrect interpretation of the term. Expenses are found on the firm’s income statement, while payables are booked as a liability on the balance sheet.
The Bottom Line
Accounts payable (AP) refer to the obligations incurred by a company during its operations that remain due and must be paid in the short term. As such, AP is listed on the balance sheet as a current liability. Typical payables items include supplier invoices, legal fees, contractor payments, and so on.
An accounting method refers to the rules a company follows in reporting revenues and expenses. The two primary methods of accounting are accrual accounting (generally used by companies) and cash accounting (generally used by individuals).
Cash accounting reports revenues and expenses as they are received and paid through cash inflows and outflows; accrual accounting reports them as they are earned and incurred through sales and purchases on credit and by using accounts receivable & accounts payable. Generally accepted accounting principles (GAAP) requires accrual accounting.
Key Takeaways
An accounting method consists of the rules and procedures a company follows in reporting its revenues and expenses.
The two main accounting methods are cash accounting and accrual accounting.
Cash accounting records revenues and expenses when they are received and paid.
Accrual accounting records revenues and expenses when they occur. Generally accepted accounting principles (GAAP) requires accrual accounting.
The Internal Revenue Services (IRS) requires accrual accounting for businesses making an average of $25 million or more in sales for the preceding three years.
Once a company chooses an accounting method, it has to stick to that method per rules set by the IRS and requires approval if it wants to change its accounting method.
Understanding an Accounting Method
All businesses need to keep accounting records. Public companies are required to do so. Accounting allows a business to monitor every aspect of its finances, from revenues to costs to taxes and more. Without accurate accounting, a business would not know where it stood financially, most likely resulting in its demise.
Accounting is also needed to pay accurate taxes to the Internal Revenue Service (IRS). If the IRS ever conducts an audit on a company, it looks at a company’s accounting records and methods. Furthermore, the IRS requires taxpayers to choose an accounting method that accurately reflects their income and to be consistent in their choice of accounting method from year to year.
This is because switching between methods would potentially allow a company to manipulate revenue to minimize their tax burdens. As such, IRS approval is required to change methods. Companies may use a hybrid of the two methods, which is allowable under IRS rules if specified requirements are met.
Types of Accounting Methods
Cash Accounting
Cash accounting is an accounting method that is relatively simple and is commonly used by small businesses. In cash accounting, transactions are only recorded when cash is spent or received.
In cash accounting, a sale is recorded when the payment is received and an expense is recorded only when a bill is paid. The cash accounting method is, of course, the method most people use in managing their personal finances and it is appropriate for businesses up to a certain size.
If a business generates more than $25 million in average annual gross receipts for the preceding three years, however, it must use the accrual method, according to Internal Revenue Service rules.
Accrual Accounting
Accrual accounting is based on the matching principle, which is intended to match the timing of revenue and expense recognition. By matching revenues with expenses, the accrual method gives a more accurate picture of a company’s true financial condition.
Under the accrual method, transactions are recorded when they are incurred rather than awaiting payment. This means a purchase order is recorded as revenue even though the funds are not received immediately. The same goes for expenses in that they are recorded even though no payment has been made.
Example of an Accounting Method
The value of accrual accounting becomes more evident for large, complex businesses. A construction company, for example, may undertake a long-term project and may not receive complete cash payments until the project is complete.
Under cash accounting rules, the company would incur many expenses but would not recognize revenue until cash was received from the customer. So, the accounting book of the company would look weak until the revenue actually came in. If this company was looking for debt financing from a bank, for example, the cash accounting method makes it look like a poor bet because it is incurring expenses but no revenue.
Under accrual accounting, the construction company would recognize a percentage of revenue and expenses corresponding to the portion of the project that was complete. This is known as the percentage of completion method. How much actual cash coming into the company, however, would be evident in the cash flow statement. This method would show a prospective lender a much more complete and accurate picture of the company’s revenue pipeline.
Accounting is the process of recording financial transactions pertaining to a business. The accounting process includes summarizing, analyzing, and reporting these transactions to oversight agencies, regulators, and tax collection entities. The financial statements used in accounting are a concise summary of financial transactions over an accounting period, summarizing a company’s operations, financial position, and cash flows.
Key Takeaways
Regardless of the size of a business, accounting is a necessary function for decision making, cost planning, and measurement of economic performance.
A bookkeeper can handle basic accounting needs, but a Certified Public Accountant (CPA) should be utilized for larger or more advanced accounting tasks.
Two important types of accounting for businesses are managerial accounting and cost accounting. Managerial accounting helps management teams make business decisions, while cost accounting helps business owners decide how much a product should cost.
Professional accountants follow a set of standards known as the Generally Accepted Accounting Principles (GAAP) when preparing financial statements.
Accounting is an important function of strategic planning, external compliance, fundraising, and operations management.
Investopedia / Jiaqi Zhou
How Accounting Works
Accounting is one of the key functions of almost any business. It may be handled by a bookkeeper or an accountant at a small firm, or by sizable finance departments with dozens of employees at larger companies. The reports generated by various streams of accounting, such as cost accounting and managerial accounting, are invaluable in helping management make informed business decisions.
The financial statements that summarize a large company’s operations, financial position, and cash flows over a particular period are concise and consolidated reports based on thousands of individual financial transactions. As a result, all professional accounting designations are the culmination of years of study and rigorous examinations combined with a minimum number of years of practical accounting experience.
History of Accounting
The history of accounting has been around almost as long as money itself. Accounting history dates back to ancient civilizations in Mesopotamia, Egypt, and Babylon. For example, during the Roman Empire, the government had detailed records of its finances. However, modern accounting as a profession has only been around since the early 19th century.
Luca Pacioli is considered “The Father of Accounting and Bookkeeping” due to his contributions to the development of accounting as a profession. An Italian mathematician and friend of Leonardo da Vinci, Pacioli published a book on the double-entry system of bookkeeping in 1494.
By 1880, the modern profession of accounting was fully formed and recognized by the Institute of Chartered Accountants in England and Wales. This institute created many of the systems by which accountants practice today. The formation of the institute occurred in large part due to the Industrial Revolution. Merchants not only needed to track their records but sought to avoid bankruptcy as well.
The Alliance for Responsible Professional Licensing (ARPL) was formed in August 2019 in response to a series of state deregulatory proposals making the requirements to become a CPA more lenient. The ARPL is a coalition of various advanced professional groups including engineers, accountants, and architects.
Types of Accounting
Accountants may be tasked with recording specific transactions or working with specific sets of information. For this reason, there are several broad groups that most accountants can be grouped into.
Financial Accounting
Financial accounting refers to the processes used to generate interim and annual financial statements. The results of all financial transactions that occur during an accounting period are summarized in the balance sheet, income statement, and cash flow statement. The financial statements of most companies are audited annually by an external CPA firm.
For some, such as publicly-traded companies, audits are a legal requirement. However, lenders also typically require the results of an external audit annually as part of their debt covenants. Therefore, most companies will have annual audits for one reason or another.
Managerial Accounting
Managerial accounting uses much of the same data as financial accounting, but it organizes and utilizes information in different ways. Namely, in managerial accounting, an accountant generates monthly or quarterly reports that a business’s management team can use to make decisions about how the business operates. Managerial accounting also encompasses many other facets of accounting, including budgeting, forecasting, and various financial analysis tools. Essentially, any information that may be useful to management falls underneath this umbrella.
Cost Accounting
Just as managerial accounting helps businesses make decisions about management, cost accounting helps businesses make decisions about costing. Essentially, cost accounting considers all of the costs related to producing a product. Analysts, managers, business owners, and accountants use this information to determine what their products should cost. In cost accounting, money is cast as an economic factor in production, whereas in financial accounting, money is considered to be a measure of a company’s economic performance.
Tax Accounting
While financial accountants often use one set of rules to report the financial position of a company, tax accountants often use a different set of rules. These rules are set at the federal, state, or local level based on what return is being filed. Tax accounts balance compliance with reporting rules while also attempting to minimize a company’s tax liability through thoughtful strategic decision-making. A tax accountant often oversees the entire tax process of a company: the strategic creation of the organization chart, the operations, the compliance, the reporting, and the remittance of tax liability.
The Accounting Profession
While basic accounting functions can be handled by a bookkeeper, advanced accounting is typically handled by qualified accountants who possess designations such as Certified Public Accountant (CPA) or Certified Management Accountant (CMA) in the United States.
In Canada, the three legacy designations—the Chartered Accountant (CA), Certified General Accountant (CGA), and Certified Management Accountant (CMA)—have been unified under the Chartered Professional Accountant (CPA) designation.
A major component of the accounting professional is the “Big Four”. These four largest accounting firms conduct audit, consulting, tax advisory, and other services. These firms, along with many other smaller firms, comprise the public accounting realm that generally advises financial and tax accounting.
Careers in accounting may vastly difference by industry, department, and niche. Some relevant job titles may include:
Auditor (internal or external): ensures compliance with reporting requirements and safeguarding of company assets.
Forensic Accountant: monitors internal or external activity to investigate the transactions of an individual or business.
Tax Accountant: strategically plans the optimal business composition to minimize tax liabilities as well as ensures compliance with tax reporting.
Managerial Accountant: analyzes financial transactions to make thoughtful, strategic recommendations often related to the manufacturing of goods.
Information and Technology Analyst/Accountant: maintains the system and software in which accounting records are processed and stored.
Controller: oversees the accounting functions of financial reporting, accounts payable, accounts receivable, and procurement.
As of December 2021, the average Certified Public Accountant in the United States made $101,779 per year.
The Accounting Rules
In most cases, accountants use generally accepted accounting principles (GAAP) when preparing financial statements in the U.S. GAAP is a set of standards and principles designed to improve the comparability and consistency of financial reporting across industries. Its standards are based on double-entry accounting, a method in which every accounting transaction is entered as both a debit and credit in two separate general ledger accounts that will roll up into the balance sheet and income statement.
In most other countries, a set of standards governed by the International Accounting Standards Board named the International Financial Reporting Standards (IFRS) is used.
Tax accountants overseeing returns in the United States rely on guidance from the Internal Revenue Service. Federal tax returns must comply with tax guidance outlined by the Internal Revenue Code (IRC). Tax accounts may also lean in on state or county taxes as outlined by the jurisdiction in which the business conducts business. Foreign companies must comply with tax guidance in the countries in which it must file a return.
Special Considerations
Accountants often leverage software to aid in their work. Some accounting software is considered better for small businesses such as QuickBooks, Quicken, FreshBooks, Xero, SlickPie, or Sage 50. Larger companies often have much more complex solutions to integrate with their specific reporting needs. This includes add-on modules or in-home software solutions. Large accounting solutions include Oracle, NetSuite, or Sage products.
The Accounting Cycle
Financial accountants typically operate in a cyclical environment with the same steps happening in order and repeating every reporting period. These steps are often referred to as the accounting cycle, the process of taking raw transaction information, entering it into an accounting system, and running relevant and accurate financial reports. The steps of the accounting cycle are:
Collect transaction information such as invoices, bank statements, receipts, payment requests, uncashed checks, credit card statements, or other mediums that may contain business transactions.
Post journal entries to the general ledger for the items in Step 1, reconciling to external documents whenever possible.
Prepare an unadjusted trial balance to ensure all debits and credits balance and material general ledger accounts look correct.
Post adjusting journal entries at the end of the period to reflect any changes to be made to the trial balance run in Step 3.
Prepare the adjusted trial balance to ensure these financial balances are materially correct and reasonable.
Prepare the financial statements to summarize all transactions for a given reporting period.
Cash Method vs. Accrual Method of Accounting
Financial accounts have two different sets of rules they can choose to follow. The first, the accrual basis method of accounting, has been discussed above. These rules are outlined by GAAP and IFRS, are required by public companies, and are mainly used by larger companies.
The second set of rules follow the cash basis method of accounting. Instead of recording a transaction when it occurs, the cash method stipulates a transaction should be recorded only when cash has exchanged. Because of the simplified manner of accounting, the cash method is often used by small businesses or entities that are not required to use the accrual method of accounting.
Imagine a company buys $1,000 of inventory on credit. Payment is due for the inventory in 30 days.
Under the accrual method of accounting, a journal entry is recorded when the order is placed. The entry records a debit to inventory (asset) for $1,000 and a credit to accounts payable (liability) for $1,000. When 30 days has passed and the inventory is actually paid for, the company posts a second journal entry: a debit to accounts payable (liability) for $1,000 and a credit to cash (asset) for $1,000.
Under the cash method of accounting, a journal entry is only recorded when cash has been exchanged for inventory. There is no entry when the order is placed; instead, the company enters only one journal entry at the time the inventory is paid for. The entry is a debit to inventory (asset) for $1,000 and a credit to cash (asset) for $1,000.
The difference between these two accounting methods is the treatment of accruals. Naturally, under the accrual method of accounting, accruals are required. Under the cash method, accruals are not required and not recorded.
The Securities and Exchange Commission has an entire financial reporting manual outlining reporting requirements of public companies.
Why Accounting Is Important
Accounting is a back-office function where employees may not directly interface with customers, product developers, or manufacturing. However, accounting plays a key role in the strategic planning, growth, and compliance requirements of a company.
Accounting is necessary for company growth. Without insight into how a business is performing, it is impossible for a company to make smart financial decisions through forecasting. Without accounting, a company wouldn’t be able to tell which products are its best sellers, how much profit is made in each department, and what overhead costs are holding back profits.
Accounting is necessary for funding. External investors want confidence that they know what they are investing in. Prior to private funding, investors will usually require financial statements (often audited) to gauge the overall health of a company. The same rules pertain to debt financing. Banks and other lending institutions will often require financial statements in compliance with accounting rules as part of the underwriting and review process for issuing a loan.
Accounting is necessary for owner exit. Small companies that may be looking to be acquired often need to present financial statements as part of acquisition or merger efforts. Instead of simply closing a business, a business owner may attempt to “cash-out” of their position and receive compensation for building a company. The basis for valuing a company is to use its accounting records.
Accounting is necessary to make payments. A company naturally incurs debt, and part of the responsibility of managing that debt is to make payments on time to the appropriate parties. Without positively fostering these business relationships, a company may find itself with a key supplier or vendor. Through accounting, a company can always know who it has debts to and when those debts are coming due.
Accounting is necessary to collect payments. A company may agree to extend credit to its customers. Instead of collecting cash at the time of an agreement, it may give a customer trade credit terms such as net 30. Without accounting, a company may have a hard time keeping track of who owes it money and when that money is to be received.
Accounting may be required. Public companies are required to issue periodic financial statements in compliance with GAAP or IFRS. Without these financial statements, a company may be de-listed from an exchange. Without proper tax accounting compliance, a company may receive fines or penalties.
Example of Accounting
To illustrate double-entry accounting, imagine a business sends an invoice to one of its clients. An accountant using the double-entry method records a debit to accounts receivables, which flows through to the balance sheet, and a credit to sales revenue, which flows through to the income statement.
When the client pays the invoice, the accountant credits accounts receivables and debits cash. Double-entry accounting is also called balancing the books, as all of the accounting entries are balanced against each other. If the entries aren’t balanced, the accountant knows there must be a mistake somewhere in the general ledger.
What Are the Responsibilities of an Accountant?
Accountants help businesses maintain accurate and timely records of their finances. Accountants are responsible for maintaining records of a company’s daily transactions and compiling those transactions into financial statements such as the balance sheet, income statement, and statement of cash flows. Accountants also provide other services, such as performing periodic audits or preparing ad-hoc management reports.
What Skills Are Required for Accounting?
Accountants hail from a wide variety of backgrounds. Generally speaking, however, attention to detail is a key component in accountancy, since accountants must be able to diagnose and correct subtle errors or discrepancies in a company’s accounts. The ability to think logically is also essential, to help with problem-solving. Mathematical skills are helpful but are less important than in previous generations due to the wide availability of computers and calculators.
Why Is Accounting Important for Investors?
The work performed by accountants is at the heart of modern financial markets. Without accounting, investors would be unable to rely on timely or accurate financial information, and companies’ executives would lack the transparency needed to manage risks or plan projects. Regulators also rely on accountants for critical functions such as providing auditors’ opinions on companies’ annual 10-K filings. In short, although accounting is sometimes overlooked, it is absolutely critical for the smooth functioning of modern finance.
The term accountant refers to a professional who performs accounting functions such as account analysis, auditing, or financial statement analysis. Accountants work with accounting firms or internal account departments with large companies. They may also set up their own, individual practices. After meeting state-specific educational and testing requirements, these professionals are certified by national professional associations.
Key Takeaways
An accountant is a professional who performs accounting functions such as account analysis, auditing, or financial statement analysis.
Accountants can find employment with an accounting firm or a large company with an internal accounting department, or they can set up an individual practice.
Many accountants choose to become Certified Public Accountants because the CPA designation is considered the gold standard in the accounting profession.
Understanding Accountants
Accountants are financial professionals who take charge of a series of accounts—either private or public. These accounts may be owned by either a corporation or individuals. As such, they may find work with corporations of different sizes—small to large—governments, different organizations like non-profits, or they may set up their own private practice and work with individuals who enlist their services.
They perform multiple accounting duties which vary based on where they work. Accountants perform account analysis, review financial statements, documents, and other reports to ensure they are accurate, conduct routine and annual audits, review financial operations, prepare tax returns, advise on areas that require more efficiencies and cost-savings, and provide risk analysis and forecasting.
An accountant’s duties often depend on the type of educational background and designation they receive. Most professionals in the field possess bachelor’s degrees and—if employed by a corporation—may require certification to move up within the firm. Certification requirements vary, with some roles requiring additional educational requirements above the bachelor’s degree and successful completion of rigorous examinations. Accountants can have more than one designation. But the most common accounting designations are the Certified Internal Auditor (CIA), Certified Management Accountant (CMA), and Certified Public Accountant (CPA). A Certified Internal Auditor doesn’t need to receive any license in order to practice, and neither do Certified Management Accountants.
Although your accountant may have more than one designation, the most common are Certified Internal Auditor, Certified Management Accountant, and Certified Public Accountant.
Many accountants choose to become CPAs because the designation is considered the gold standard in the accounting profession. In the United States, certification requirements for accountants can vary from state to state. But there is one requirement that is uniform in every state—the passing of the Uniform Certified Public Accountant Examination. This is an exam that is written and graded by the American Institute of Certified Public Accountants (AICPA).
Special Considerations
Accountants must abide by the ethical standards and guiding principles of the region where they practice, such as the International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP). The IFRS is a set of rules issued by the International Accounting Standards Board (IASB). These rules promote consistency and transparency in financial statements. GAAP, on the other hand, is a set of standards that accountants must adhere to when they complete financial statements for any publicly-traded companies.
Certified public accounts are legally and ethically responsible to be honest, trustworthy, and to avoid negligence in their duties. CPAs have real influence over their clients, which means their judgment and work can affect not just an individual but an entire company—including its employees, its board, and its investors. Accountants may be held liable for paying uninsured losses to creditors and investors in the case of a misstatement, negligence, or fraud.
Accountants can be held liable under two different types of law—common law and statutory law. Common law liability includes negligence, fraud, and breach of contract, while statutory law includes any state or federal securities laws.
History of Accountants
The first professional association for accountants, the American Association of Public Accountants, was formed in 1887, and CPAs were first licensed in 1896. Accounting grew as an important profession during the industrial revolution. This was largely due to the fact that businesses grew in complexity and the shareholders and bondholders, who were not necessarily a part of the company but were monetarily invested, wanted to know more about the financial well-being of the companies they were invested in.
After the Great Depression and the formation of the Securities and Exchange Commission (SEC), all publicly traded companies were required to issue reports written by accredited accountants. This change increased the need for corporate accountants even further. Today, accountants remain a ubiquitous and crucial part of any business.
