Accounts Payable: Definition & Functions (Small Business Accounting)

Trevor Williams/DigitalVision/GettyImages

Do you really know what you owe to your suppliers, creditors and vendors? If you don't keep track, you may end up buried in debt and pay late fees. An effective accounts payable system can make it easier to manage what you owe. This way, you will know when your payments are due and will maintain accurate financial records.

TL;DR (Too Long; Didn't Read)

Record any loans you take out and any goods or services purchased on credit in your accounts payable. This accounting entry represents short-term debt payments owed to suppliers or creditors.

What Is Accounts Payable?

Few business owners have low or no capital requirements. There are times when you need funds to create new products, hire more people or open new offices. One option is to reach out to investors, but you risk losing control of your small business. Considering these aspects, it makes sense to apply for a loan — just make sure you keep track of what you owe and make timely payments to creditors.

When a company takes out small-business loans or purchases goods or services on credit, it needs to record the amounts owed. These amounts should be recorded as a liability on its balance sheet. Basically, the company must record any bills or invoices for products or services purchased on credit in its liability account "accounts payable". This accounting entry appears under current liabilities.

Accounts payable, or AP, consists of what you owe to creditors and vendors. Generally, it includes short-term debt liabilities that you plan to repay within days or months but no longer than one year. Once those payments are made, the corresponding amounts are reduced from your AP balance to mark your bills as paid. The creditors or vendors record the unpaid balance in their general ledger account called "accounts receivable," or AR.

The credit balance in AP should be equal to the amounts owed to suppliers that have been recorded but haven't been paid. In general, companies are not charged interest on the balance if they pay on time. Mortgages and other long-term debts are recorded as separate liabilities, not accounts payable. Using a good AP system allows you to see what you owe, keep track of your bills and avoid missing payments.

Accounts Payable vs. Accounts Receivable

A company's accounts payable is another company's accounts receivable. Basically, these are two sides of the same coin. Accounts payable is what you owe creditors and suppliers. These amounts are recorded as accounts receivable on their books. At the time of payment, both the accounts payable and accounts receivable decrease.

Payables are recorded as current liabilities. Receivables, on the other hand, are recorded as current assets. For example, if your company purchases new computers on credit, this expenditure goes to your AP account. At the same time, the supplier creates an account receivable and records the transaction as revenue.

To put it simply, accounts receivable is the amount of money that a company is owed. Both accounts are equally important because they help businesses know what they have to pay and how much they will receive. A major difference between the two is that AP leads to a decrease in cash flow, while AR causes an increase in cash flow.

Accounts Payable Process

The accounts payable process varies among companies. In general, large organizations have their own AP department that records and manages vendor contact information and payments, internal reimbursement payments, business travel expenses and more. This department may also be responsible for developing strategies to reduce costs, handle preapproved purchase orders or administer petty cash.

Small businesses, on the other hand, typically do the bookkeeping and then outsource accounting or do their own taxes. Their AP and AR tasks are handled by the same person, not an entire department. The accounts payable process is quite straightforward and has four steps:

  • Receive and review the bills: Make sure the bill and purchase order includes the vendor's name and legal information, timelines for delivery, due date, unit prices and other relevant details.

  • Process the receiving report: This document lists the goods received along with a detailed description that should match the information on the purchase order.

  • Update your records: Create an expense entry and list the payment owed to the vendor to update your ledger accounts.

  • Pay the bill: Once the payment is made, the amount will be deducted from the AP account and recorded as an expense or asset in another account.

Consider centralizing your accounts payable department to have everything in one place. If possible, set up supplier portals so that vendors can electronically track the status of their orders and payments received. Use an accounting program to keep your bills and invoices organized, reduce manual work and prevent human error. Also, it's essential to maintain detailed contract records to avoid fraud and have a clear picture of the vendors with which you're doing business.

Be Aware of Accounts Payable Fraud

Accounts payable fraud is extremely common and may include billing schemes, check tampering, asset misappropriation and more. Employees may hide fraudulent transactions among legitimate transactions, create false invoices for goods that were not delivered or set up fake vendor accounts and issue invoices. For this reason, it's crucial to have an effective AP system in place and check every detail on your bills, invoices and receiving reports.

If you work with dozens of vendors, double check their identity to ensure their business information is legitimate. Look out for invoices that are missing key details, large payments to one vendor, rounded dollar amounts, duplicate payments to the same supplier, vendors with similar names, invoices in sequence and checks issued for round amounts. These are all red flags that something isn't right.

AP fraud schemes often take longer than two years to be detected, so you may end up losing hundreds of thousands of dollars before realizing what's going on. Incorporate strong internal controls to optimize the accounts payable process, mitigate risks and ensure financial compliance. Closely examine any documents that could be relevant, including payment registers, journal entries, vendor contractors, invoices and other evidence.

Optimize Your Accounts Payable System

Any business big or small needs to keep track of all the payments that are due. Failure to pay on time can result in interest charges and penalties. Plus, it may affect a company's relationships with vendors and harm its reputation. Having a good accountable payable system in place will ensure timely payments and accurate record keeping.

First of all, try to reduce or eliminate manual processes. Leverage automation to streamline your accounting and track invoices accurately. Consider using FreshBooks, Zoho Books, NetSuite ERP, QuickBooks Enterprise or Xero. These software programs automate invoice and payment processes while decreasing the risk of human error.

Sage Business Cloud Accounting, for example, is designed for startups and small businesses, featuring a user-friendly interface where users can see recurring invoices, purchases, bank statements, reports and more. A major advantage is that you can add multiple users, such as your accountant or employees, which helps streamline collaboration and increase work efficiency.

Ideally, choose an accounting system that offers cloud storage. This way, you will have 24/7 access to your accounting information and will centralize your accounts payable and accounts receivable systems. Consider paying your bills in batches rather than individually; set a few hours aside each week for this task. If you prefer to hire an accountant, make sure you have clear procedures in place for him to follow.