Both AP and AR help in understanding the financial situation of an organization at any given point in time. Accounts Payable states how much a business needs to pay out, whereas accounts receivable discloses about how much a business can expect to receive in the near future. They create a different impact on the company's liquidity in the short term.
There are some key differences between accounts payable and accounts receivable that have been discussed in this blog. We also discuss simple examples inspired by real use cases to better explain the concept of Accounts Receivable and Accounts Payable. Furthermore, the blog highlights a few common practices that organizations use to ensure they are able to manage their AR and AP well.
So, let's jump right into it:-
What is Accounts Payable?
Accounts payable or AP is the amount which is due and needs to be paid in the near future to a creditor. It works on a short-term debt mechanism which is why the company treats it as a current liability.
Accounts Payable use-case
Let’s look at a small example of Accounts Payable or AP.
A bakery, BakersHome, has just seen a rise in its business and analyzed that the demand for their products will increase in the near future. Therefore, they want to procure more raw material than they usually do from their supplier, Good Food Pvt Ltd. The supplier gives them an invoice of ₹12,500, dated on 1th December. Both the bakery, and supplier mutually agreed to a net 30-days deal for settlement of the payment with ₹2,500 payment upfront.
Total Payment Due - ₹12,500
Advance Payment - ₹2,500
Amount Payable by BakersHome - ₹10,000
Amount Receivable by Good Food Pvt Ltd. - ₹10,000.
It can be understood that on 15th December, BakersHome created an Accounts Payable of ₹10,000, and Good Food Pvt Ltd. made an Accounts Receivable of the same amount.
What is Accounts Receivable?
Accounts Receivable (AR) refers to an amount that is owed by an individual or a company for the goods sold/services rendered. This amount is paid in the near future, usually within a 30 to 90 day period. It is treated as a current asset and is recorded in the balance sheet under the current asset category. The reason for recording the Account Receivable as a current asset is that it can be liquidated in cash after the due payment is received. But if the payment is received after a year, it will be considered a long-term asset.
Unlike Accounts Payable, Accounts Receivable is entitled to a risk of the customer not being able to pay the credit amount. Therefore, that risk is mitigated via an allowance for doubtful debts account. There could be situations when the balance amount in Accounts Receivable is more than the reported revenue for any particular period because Account Receivable can hold both current and old receivables.
If a company only allows for total payment upfront and no credit sale, there will be no Accounts Receivable.
The interaction begins with the company and the customer. If the sale or delivery is made for a product/service, the customer will receive an invoice from the company. The payment is due on a decided extended date, usually, a duration of 30-90 days from the purchase date or what the seller and the buyer agree upon. They can even pay the due amount in regular instalments with mutual consent from the customer and the company. Once the company receives the entire due amount, they write off that amount from the Account Receivable balance.
Accounts Receivable use-case
A fan manufacturer is given an order of 50 units of fans. The total cost of the entire order is estimated to be ₹5,00,000.
The manufacturer grants a credit period of 30 days to their customer for the complete payment of the order. Till the due date, the manufacturer maintains an Accounts Receivable of ₹5,00,000.
When the customer clears the payment after 30 days of initial purchase, the manufacturer will make an adjustment to the balance sheet by increasing the cash amount by ₹5,00,000 and decreasing Accounts Receivable by the same number.
Difference between Accounts Receivable and Accounts Payable
Accounts Receivable (AR) and Accounts Payable (AP) seem indistinctive on the surface, but there are some key points to remember when either is mentioned. Here are some of the differences in Account Receivable and Account Payable. These differences can be used to quickly identify both these accounts with ease.
Important practices in Accounts Receivable and Accounts Payable
- At a unit level, all invoices are payable to a party that becomes the receivable who creates an Accounts Receivable for that party against the invoice.
- A company doesn't have to have both Accounts Receivable and Account Payable simultaneously or in their business life cycle. There can be a company that does not allow credit sales and a company that pays all the cash upfront on the date of purchase.
- From a management perspective, the common practice is to handle these functions separately. The motive behind this is to minimize the risk of fraud. It is also good that the one paying bills is not generating invoices for your business.
- Many companies from different workflows manage their Accounts Receivable (AR) and Account Payable (AP). It reduces the chances of error and increases efficiency.
- Establishing guidelines and exercising discretion to whom we are making credit sales can help identify the customer's behavior.
- The process for Account Payable and Accounts Receivable helps manage the outstanding pays and checks if a particular amount is past the due date and is due soon. Some businesses automate the entire process to manage their AR and AP so there are minimal errors and more reliable results.
Similarities between Accounts Payable and Accounts Receivable
- An individual transaction for a specific Account Payable will have the same amount recorded for Account Receivable, and vice versa.
- Both Accounts are recorded in the company's ledgers. Accounts Payable is recorded as a liability account, whereas Accounts Receivable is recorded as an asset account.
- Both AP and AR are helpful to better plan and management of cash flow and reporting.
Benefits of automating Accounts Receivable and Accounts Payable
1. Less Time Spent
Having an automated process for AR and AP enables a company to save time. Features like integrating to the accounting system, regular standard reminders, and real-time updates make it less time-consuming than manually handling the workflow.
2. Keep a check for payment problems
Despite it being an automation tool, it can gather data and analyze patterns over time to pinpoint problems.
3. Single source transparency
Due to automation, both business and customers interact on a single source, making Accounts Payable and Accounts Receivable more translucent.
4. Improved cash flow
Accurate calculations and forecasting for receiving payment via automated Accounts Receivable provide a better plan to manage the business' cash flows.
5. Better alternatives for resources
Manually handling Accounts Receivable and Accounts Payable also uses resources such as the cost of holding different departments and cost of an employee. An automated process will help you put that money to better use.
Accounts Receivable and Accounts Payable go hand in hand. Knowing the basic differences, such as AP being categorized as a liability and AR being an asset, creates the basis to understand why they are treated differently in accounting. Despite their differences, they can be an extremely rewarding tool to manage cash flows and cash in hand if used correctly. Businesses that rely on credit sales can manage their Accounts Receivable and Accounts Payable via automation to be more efficient.