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This article is for informational purposes only and does not constitute legal, accounting, or tax advice. The information contained herein is subject to change and may vary from time to time in your region. For specific advice applicable to your business, please contact a professional.
If you’re a business owner, you should know the difference between accounts payable (AP) and accounts receivable (AR). These two types of accounts are similar in the way they’re recorded, but it’s important to differentiate between them because accounts receivable is an asset and accounts payable is a liability.
Read on to learn more about accounts payable (AP) and accounts receivable (AR) and how they work.
What is accounts payable?
Accounts payable (AP) is the amount of money a business owes to its creditors. When you buy goods and services on credit that needs to be repaid within a year, this amount owed becomes part of your accounts payable. Accounts payable is recorded on a balance sheet as a current liability.
Accounts payable or AP is also used to refer to a team or department within an organisation that’s responsible for managing and making these payments.
What is accounts receivable?
Accounts receivable (AR) is the balance of money a business is owed for the goods and services they’ve delivered but not yet received payment for. In simple terms, it’s the money you’re owed by customers who you’ve extended credit to.
Your business’s total accounts receivable is the sum of all outstanding invoices. Once you send an invoice, it becomes part of your accounts receivable until it’s paid. Accounts receivable is recorded on your balance sheet as a current asset, indicating that the balance is due in a year or less.
What’s the difference between accounts payable and accounts receivable?
Accounts payable and accounts receivable are essentially opposites.
Say you own a pizza shop and buy cheese to top your pizzas. The cheese supplier then sends you a bill for this cheese. You would record this invoice as accounts payable (AP), as you need to pay the supplier within their credit terms. The cheese supplier would record this same amount as accounts receivable (AR), as it’s money they’re waiting to receive. Both the pizza shop and cheese supplier will have a series of suppliers and customers reflecting in their accounts payable and accounts receivable ledgers.
What’s the role of accounts payable?
Accounts payable is a financial classification, but the term is also used to describe the person or people who manage the accounts payable (AP) process.
An AP team is responsible for more than incoming bills and invoices. They also track the total amount owed to creditors, ensure payments have been approved before they’re processed, and help minimise fraud. A quality accounts payable team will also build strong working relationships with suppliers by making sure their bills are paid on time. By creating trust, they may be able to negotiate more favourable credit terms in the future.
How does the accounts payable (AP) process work?
An accounts payable team will have a set of processes to follow before making a creditor payment. These procedures and rules will vary by business. In addition to ensuring you meet your payment obligations, these internal controls will safeguard your business against paying inaccurate or fraudulent invoices or paying invoices twice.
The accounts payable process generally involves:
- Receiving the invoice. Once you’ve bought goods or services from a supplier, you’ll receive an invoice requesting payment.
- Reviewing invoice details. The AP team will check that the invoice corresponds with the relevant purchase order and includes all necessary information. The Australian government requires that tax invoices include seven key pieces of information to be considered valid.
- Updating your records. Once confirmed, AP will enter the invoice data into your accounting system.
- Seeking payment approval. Most businesses have an approval process for invoices above a certain value.
- Making payment. Payment should be processed on or before the due date, and the amount should be removed from your accounts payable ledger.
What is the role of accounts receivable?
An accounts receivable team is responsible for ensuring your business receives payment for the goods and services you’ve provided.
The AR team maintains your billing system. They’ll generate invoices and account statements, reconcile your accounts and work with your debtors to make sure outstanding payments are made within the agreed credit terms. Accounts receivable teams commonly produce regular financial and management reports, and work with the management team to manage debtors and credit terms – relaxing these where a customer has shown a strong payment history or tightening them up if late or partial payments start to occur.
How does the accounts receivable process work?
An effective and consistent accounts receivable process is an essential part of maintaining a healthy cash flow. The three key steps are:
- Sending the invoice. Your AR team should always send an invoice immediately after you’ve delivered your product or service.
- Tracking the invoice. The team will monitor your bank account for payment (or you might have accounting software that does this automatically). If you haven’t received payment by the due date, accounts receivable should follow up with the customer and update your books with an expected payment date.
- Receiving the payment. Once payment is received, the AR team will mark the invoice as paid and credit your accounts receivable ledger.
It’s not always that simple, of course. If your customer refuses to pay, you should follow a documented debt collection process. If you’re not successful at recovering the payment internally, you may need to refer the matter to a debt collection agency.
Managing your accounts payable and accounts receivable can seem daunting if accounting isn’t your thing. However, these aspects have a significant impact on one of your most important financials – your cash flow. Regardless of your business’s size, you should understand accounts payable versus accounts receivable, have documented processes for both, and constantly look for opportunities to optimise your AP and AR approach.