What is Accounts Payable - Meaning, Process, Examples, Formula

Effective accounts payable management improves company's working capital. It is made possible by strategically  timing the payments and getting favorable negotiating terms with vendors. Accounts payables are outstanding bills such as contractor and supplier invoices that make up a company’s short-term debt obligations. Continue reading to understand the accounts payable process, formula, and examples.

What is Accounts Payable? 

Accounts payable (AP) is the money a business owes its suppliers for goods and services purchased on credit. It is a current liability in the balance sheet, representing the total of approved and unpaid invoices from the suppliers. Companies must pay these unpaid invoices on time to avoid defaults. 

The accounts payable of a company display its short-term debt obligations and impact on cash flow. When a business purchases goods on credit but this needs to be paid back in a short time period. This is known as Accounts Payable. If the payables increase over time, it indicates that the company buys more products on credit. If the payables decrease, it could imply that the company is paying off its obligations faster than they purchase new goods or services on credit.

Key Components of Accounts Payable

Accounts payable may not be in exact term on your ERP. It may be named in different types. The following are some of the key components of accounts payable-

• Vendor invoices- These refer to bills raised on your company by your suppliers to make purchases for making and selling of products or services. 
• Utilities to run the company- There are many operating expenses incurred to run the company. Utilities such as electricity, water, telephone, internet, etc form primary expenses that are billed on the company and become payable at regular intervals.
• Employee reimbursements- Employees often incur expenses on behalf of the company that must be compensated by the company. These are reimbursement that is accounted on accounts payable.
• Accruals and bills payable- Certain payables may be incurred but not paid which have to be accounted for such as wages, interest, taxes and any other financial liabilities. 

Objectives of Managing Accounts Payable Effectively 

It is important to understand the importance of accounts payable to manage the liabilities and expenses of the business and leverage the opportunity for cost savings. Some common objectives of managing accounts payable effectively include:

• To make timely payments to suppliers, which helps maintain good relationships
• To maintain accurate data that ensures proper expense management, avoids errors, and supports compliance requirements. 
• To research ways to save money, optimize cash flows and increase the efficiency of the accounts payable process. 

Example of Accounts Payable

The following are examples of accounts payable and a typical accounts payable process:

Example 1: Let’s assume company A purchases coffee machines from Company B on credit. B determines that the amount needs to be paid in 30 days. A records the sale as a credit sale and B is a creditor with an accounts payable balance. On the other hand, B records the sale as accounts receivable. 

B sends an invoice to A 15 days before the payment due date. A tallies the invoice with the purchase order, gets the requisite approvals and processes the payment by the end of the month. 

Example 2: XYZ Ltd. requires transportation of goods from their factory to their warehouses. They create a purchase order (PO) detailing the transportation service requirements, and any special instructions, along with the agreed-upon price of Rs. 50,000. 

Mr.A receives the PO and carries out the transport services. Post completion of the service, Mr.A issues an invoice to XYZ Ltd. for Rs.50,000, due in 45 days. XYZ Ltd. receives the invoice and proceeds to undertake a reconciliation between the purchase order and the invoice, as well as an enquiry with the concerned department to check whether the transportation was done as per the specifications and terms outlined in the PO. If the reconciliation does not yield any mismatches, XYZ Ltd. then records the invoice in their books and Mr.A as an accounts payable creditor along with the amount owed to them. 

XYZ Ltd. then undertakes the necessary reviews and approvals, based on their internal policies and procedures. Once the invoice has been approved, XYZ Ltd. initiates the payment process and makes the payment to Mr.A before the due date. Once paid, XYZ Ltd. updates their accounts payable records to reflect the as well as ensure that their financial records accurately reflect their current liabilities.

Why Are Accounts Payable and Its Management Important?

Accounts payable and its management is vital for the smooth functioning process of any business entity. It is important for any business because:

• It primarily takes charge of paying the entity’s bills on a timely basis. This is important so that strong credit and long-term relationships with the vendors can be maintained.
• Only when invoices are paid on time, vendors will ensure an uninterrupted flow of supplies and services; which in turn will help in the systematic flow of business.
• A good accounts payable process ensures there are no overdue charges, penalty or late fees to be paid for the dues.
• The organized accounts payable process ensures all that the invoices due are tracked and paid properly. This will help avoid missing payments and making a payment twice.
• It also enables business entities to manage better cash flows (i.e. making payments only when due, using the credit facility provided by the vendor, etc.)
• Frauds and thefts can be avoided to a greater extent by following a stringent accounts payable process.

For a company’s financial statements to be complete and accurate, the accounts payable balances should be recorded with accuracy. These payables must be dealt with efficiently and accurately.

If there is a double-entry of an expense or omission of a particular invoice, the financial statements will not report the correct amounts and the loss will be huge when the numbers involved are big. Hence, proper recording of the expense and tracking of the payment is necessary.

Accounts Payable Process

The AP process is receiving the invoices, reviewing their details, updating the internal records, and making payments: 

Invoice capture:

1. The company receives the invoice from the vendor.

2. The accounts payable department matches the invoice against the purchase order, or even goods received note (in 3-way matching) or inspection report (in 4-way matching), to approve the final payment. 

Invoice approval:

3. They get the necessary approvals from the internal departments.

4. They record the invoice in an accounting system as a liability.

Payment authorisation:

5. Once approved, the accounts payable/finance department schedules the payment according to the payment terms and ensures sufficient cash flow remains to meet other obligations.

Payment execution:

6. The payment is processed using a cheque, credit card, or electronic fund transfer method.

7. The payment is recorded in the accounting book. 

What is the P2P Process in Accounts Payable 

The P2P process in accounts payable is a part of the larger accounts payable cycle, also known as the procure-to-pay or P2P cycle. It is an end-to-end process of accounts payable and involves processes from when the company decides to purchase, selecting the products to buy, and paying for them: 

1. The company determines the products it wants to buy and gets approval.
2. It starts searching for vendors and partners and selects a few. 
3. It receives quotations and selects the one that matches its needs.
4. It negotiates rates, credit policy, discounts, delivery, and freight charges.
5. It generates purchase orders and sends the purchase order to the selected suppliers. 
6. The supplier confirms the order at the requested terms and conditions. 
7. The supplier ships the goods and informs the company. 
8. The company formally receives the goods, inspects the delivery for quality and quantity, and sends the invoice for approval. 
9. Post-approval, the company initiates and processes the payment and informs the vendor. It also marks the payment as complete.

How to Record Accounts Payable

For every amount debited, there has to be a corresponding credit in the double-entry system of accounting. When an invoice is received, the AP account is credited. An expense or goods/services purchase or a fixed asset account would be debited. Later on, when the invoice is paid out, the AP account is debited which reduces the liability. Cash or bank account is debited.

Challenges in the Accounts Payable Process 

The accounts payable process can face challenges that affect the value of the payment process. Some common challenges are as follows: 

• Manual accounts payable processing can be slow and inefficient, leading to delayed payments, missed discounts, and poor vendor relationships. 
• Payment errors can result from human mistakes or lack of proper invoice matching, which can cause audit risks, disputes with vendors, and financial losses. 
• Manual bookkeeping can also be prone to errors and inconsistencies, making it difficult to track AP performance. 
• Manual data entry can also be time-consuming and may result in errors that can feed into the system and compromises compliance. It also increases the risk of fraud. 
• Different vendors have different formats of invoices, approval workflows, and delivery methods — this inconsistency can lead to discrepancies and disputes, which require manual intervention and therefore more time to process the invoices.

Automation in Accounts Payable

As the accounts payable process is vital for every organization, a lot of time needs to be invested for its successful implementation. In order to have an efficient accounts payable process, automation becomes necessary. This will minimise the time and cost of invoice processing, employee headcount and much more. Accounts payable automation will also help reduce human errors and increase efficiency.

Accounting software available in the market can streamline the accounts payable process. These eliminate most of the paperwork involved in accounting. Using electronic invoices, scanned copies of reports, email approvals, etc., will not only reduce the time involved in managing the payables but will also improve the day-to-day performance of the businesses. To add, they usually integrate with the organizations ERP. There are many other value-added services which can be availed from this accounting software. They ultimately improve business efficiency.

Benefits of Accounts Payable Automation

Automating the accounts payable process yields several benefits, such as:

• Faster invoice processing: Automation drastically reduces the invoice processing time as the same functions can now be performed with a click of a button, whether it is for invoice capture, approvals, data matching, or payment tracking.
• Lower processing costs: With faster processing times also comes lower costs. Automation reduces the need for manual data entry and paper-based processing of invoices, thereby cutting down on manpower costs and administrative overheads.
• Increased accuracy: Automation reduces manual work, eliminating the chances of human errors in data entry and calculations. It also promotes digital tracking and checks for duplicates, etc., ensuring that the data is always 100% accurate. 
• Access to an audit trail: AP automation provides the management with a detailed and transparent audit trail for every invoice. Right from invoice receipt to payment, finance leaders can view all activities and transactions, thereby increasing accountability within the organisation.
• Faster invoice cycle times: Automation enables faster invoice processing, thereby facilitating faster payments and overall faster invoice cycle times. By having the opportunity to pay vendors well before the due date, businesses can take advantage of early payment discounts. This also enhances vendor relationships.
• Enhanced visibility and reporting: Automation provides real-time tracking and visibility into a business’s AP process and liabilities. This transparency enables better decision-making, cash flow optimisation, and cost control through insightful reports.
• Streamlined compliance: Digitised records promote better compliance as anomalies can be easily detected and rectified, thereby keeping penalties and government notices at a minimum.

Accounts Payable Best Practices

The accounts payable process is important for sustaining good cash flows and building strong vendor relationships. However, AP teams often encounter problems such as missing invoices, incorrect data entries, data mismatches, delayed payments, and more.  Hence, it is crucial that every business implement certain best practices to improve their accounts payable process and avoid such problems from arising. 

Here are the top ten best practices to improve your accounts payable process. Let's summarise these below-

• Use central repository to consolidate the checks to improve the process
• Ensure there is limited access to the Master Vendor File
• Run checks on how accidental frauds can take place by creating fake vendor accounts 
• Negotiate for favourable payment terms for higher cash flows
• Always go for seeking discounts from vendors to reduce the cash your business pays
• Ensure you are alerted about any duplicate records
• Ensure all invoices match what your policy. In case these don't match, find out the reasons.
• Conduct reviews of all accounts every day end.

Key Takeaways

The accounts payable process plays a significant role in any business as it directly impacts cash flows. Efficient management of accounts payable ensures that invoices are paid on time, helping maintain positive relationships with vendors while avoiding late payment penalties. By closely monitoring and optimising this process, businesses can better control their working capital and improve their financial stability. 

Further, under the Goods and Services Tax (GST) laws in India, businesses can claim input tax credit only if their vendors upload invoices on time. For this reason, it is of even more importance to maintain healthy vendor relationships and effective vendor communication. 

AP Automation helps streamline the accounts payable process by reducing manual tasks, thereby minimising errors and delays. This efficiency enhances productivity and ensures that invoices are paid promptly, improving supplier relationships and potentially securing early payment discounts.