Accounts Payable

Introduction to Accounts Payable

When a company orders and receives goods (or services) in advance of paying for them, we say that the company is purchasing the goods on account or on credit. The supplier (or vendor) of the goods on credit is also referred to as a creditor. If the company receiving the goods does not sign a promissory note, the vendor's bill or invoice will be recorded by the company in its liability account Accounts Payable (or Trade Payables).

As is expected for a liability account, Accounts Payable will normally have a credit balance. Hence, when a vendor invoice is recorded, Accounts Payable will be credited and another account must be debited (as required by double-entry accounting). When an account payable is paid, Accounts Payable will be debited and Cash will be credited. Therefore, the credit balance in Accounts Payable should be equal to the amount of vendor invoices that have been recorded but have not yet been paid.

Under the accrual method of accounting, the company receiving goods or services on credit must report the liability no later than the date they were received. The same date is used to record the debit entry to an expense or asset account as appropriate. Hence, accountants say that under the accrual method of accounting expenses are reported when they are incurred (not when they are paid).

The term accounts payable can also refer to the person or staff that processes vendor invoices and pays the company's bills. That's why a supplier who hasn't received payment from a customer will phone and ask to speak with "accounts payable."

The accounts payable process involves reviewing an enormous amount of detail to ensure that only legitimate and accurate amounts are entered in the accounting system. Much of the information that needs to be reviewed will be found in the following documents:

• Ø  purchase orders issued by the company
• Ø  receiving reports issued by the company
• Ø  invoices from the company's vendors
• Ø  contracts and other agreements

The accuracy and completeness of a company's financial statements are dependent on the accounts payable process. A well-run accounts payable process will include:

• Ø  The timely processing of accurate and legitimate vendor invoices,
• Ø  Accurate recording in the appropriate general ledger accounts, and
• Ø  The accrual of obligations and expenses that have not yet been completely processed.

The efficiency and effectiveness of the accounts payable process will also affect the company's cash position, credit rating, and relationships with its suppliers.

 Accounts Payable Process

The accounts payable process or function is immensely important since it involves nearly all of a company's payments outside of payroll. The accounts payable process might be carried out by an accounts payable department in a large corporation, by a small staff in a medium-sized company, or by a bookkeeper or perhaps the owner in a small business.

Regardless of the company's size, the mission of accounts payable is to pay only the company's bills and invoices that are legitimate and accurate. This means that before a vendor's invoice is entered into the accounting records and scheduled for payment, the invoice must reflect:

• What the company had ordered
• What the company has received
• The proper unit costs, calculations, totals, terms, etc.

To safeguard a company's cash and other assets, the accounts payable process should have internal controls. A few reasons for internal controls are to:

• Prevent paying a fraudulent invoice
• Prevent paying an inaccurate invoice
• Prevent paying a vendor invoice twice
• Be certain that all vendor invoices are accounted for

Periodically companies should seek professional assistance to improve its internal controls.

The accounts payable process must also be efficient and accurate in order for the company's financial statements to be accurate and complete. Because of double-entry accounting an omission of a vendor invoice will actually cause two accounts to report incorrect amounts. For example, if a repair expense is not recorded in a timely manner:

1. The liability will be omitted from the balance sheet, and
2. The repair expense will be omitted from the income statement.

If the vendor invoice for a repair is recorded twice, there will be two problems as well:

1. The liabilities will be overstated, and
2. Repairs expense will be overstated.

In other words, without the accounts payable process being up-to-date and well run, the company's management and other users of the financial statements will be receiving inaccurate feedback on the company's performance and financial position.

A poorly run accounts payable process can also mean missing a discount for paying some bills early. If vendor invoices are not paid when they become due, supplier relationships could be strained. This may lead to some vendors demanding cash on delivery. If that were to occur it could have extreme consequences for a cash-strapped company.

Just as delays in paying bills can cause problems, so could paying bills too soon. If vendor invoices are paid earlier than necessary, there may not be cash available to pay some other bills by their due dates.

Purchase order

A purchase order or PO is prepared by a company to communicate and document precisely what the company is ordering from a vendor. The paper version of a purchase order is a multi-copy form with copies distributed to several people. The people or departments receiving a copy of the PO include:

• The person requesting that a PO be issued for the goods or services
• The accounts payable department
• The receiving department
• The vendor
• The person preparing the purchase order

The purchase order will indicate a PO number, date prepared, company name, vendor name, name and phone number of a contact person, a description of the items being purchased, the quantity, unit prices, shipping method, date needed, and other pertinent information.

One copy of the purchase order will be used in the three-way match, which we will discuss later.

Receiving report

A receiving report is a company's documentation of the goods it has received. The receiving report may be a paper form or it may be a computer entry. The quantity and description of the goods shown on the receiving report should be compared to the information on the company's purchase order.

After the receiving report and purchase order information are reconciled, they need to be compared to the vendor invoice. Hence, the receiving report is the second of the three documents in the three-way match (which will be discussed shortly).

Vendor Invoice

The supplier or vendor will send an invoice to the company that had received the goods and/or services on credit. When the invoice or bill is received, the customer will refer to it as a vendor invoice. Each vendor invoice is routed to accounts payable for processing. After the invoice is verified and approved, the amount will be credited to the company's Accounts Payable account and will also be debited to another account (often as an expense or asset).

A common technique for verifying a vendor invoice is the three-way match.

Three-way match

The accounts payable process often uses a technique known as the three-way match to assure that only valid and accurate vendor invoices are recorded and paid. The three-way match involves the following:

Only when the details in the three documents are in agreement will a vendor's invoice be entered into the Accounts Payable account and scheduled for payment.

Good internal control of a company's resources is enhanced when the company assigns a separate employee with a specific, limited responsibility. The following chart illustrates the concept of the separation (or segregation) of duties involving accounts payable:

When the duties are separated, it will require more than one dishonest person to steal from the company. Hence, small companies without sufficient staff to separate employees' responsibilities will have a greater risk of theft.

To illustrate the three-way match, let's assume that BuyerCo needs 10 cartridges of toner for its printers. BuyerCo issues a purchase order to SupplierCorp for 10 cartridges at $60 per cartridge that are to be delivered in 10 days. One copy of the PO is sent to SupplierCorp, one copy goes to the person requisitioning the cartridges, one copy goes to the receiving department, one copy goes to accounts payable, and one copy is retained by the person preparing the PO. When BuyerCo receives the cartridges, a receiving report is prepared.

The three-way match involves comparing the following information:

1. The description, quantity, cost and terms on the company's purchase order.
2. The description and quantity of goods shown on the receiving report.
3. The description, quantity, cost, terms, and math on the vendor invoice.

After determining that the information reconciles, the vendor invoice can be entered into the liability account Accounts Payable. The information entered into the accounting software will include invoice reference information (vendor name or code, invoice number and date, etc.), the amount to be credited to Accounts Payable, the amount(s) and account(s) to be debited and the date that the payment is to be made. The payment date is based on the terms shown on the invoice and the company's policy for making payments.

Lastly, the documents should be stamped or perforated to indicate they have been entered into the accounting system thus avoiding a duplicate payment.

Vouchers

Some companies use a voucher in order to document or "vouch for" the completeness of the approval process. You can visualize a voucher as a cover sheet for attaching the supporting documents (purchase order, receiving report, vendor's invoice, etc.) and for noting the approvals, account numbers, and other information for each vendor invoice or bill.

When the vendor invoice is paid, the voucher and its attachments (including a copy of the check that was issued) will be stored in a paid voucher/invoice file. If paper documents are involved, an office machine could perforate the word "PAID" through the voucher and its attachments. This is done to assure that a duplicate payment will not occur.

The unpaid invoices and vouchers will be held in an open file.

Vendor invoices without purchase orders or receiving reports

Not all vendor invoices will have purchase orders or receiving reports. Hence, the three-way match is not always possible. For example, a company does not issue a purchase order to its electric utility for a pre-established amount of electricity for the following month. The same is true for the telephone, natural gas, sewer and water, freight-in, and so on.

There are also payments that are required every month in order to fulfill lease agreements or other contracts. Examples include the monthly rent for a storage facility, office rent, automobile payments, equipment leases, maintenance agreements, etc. Even though these obligations will not have purchase orders, the responsibility is unchanged: pay only the amounts that are legitimate and accurate.

Statements from vendors

Vendors often send statements to their customers to indicate the amounts (listed by invoice number) that remain unpaid. When a vendor statement is received the details on the statement should be compared to the company's records.

The fact that a company can be receiving both invoices and statements from a vendor means there is the potential of a duplicate payment. In order to avoid making a duplicate payment, companies often establish the following rule: Pay only from vendor invoices; never pay from vendor statements.

Accrued Expense and Income

Accrued Expense

Accrued expense is expense which has been incurred but not yet paid. Expense must be recorded in the accounting period in which it is incurred. Therefore, accrued expense must be recognized in the accounting period in which it occurs rather than in the following period in which it will be paid.

As expense will be debited to record the accrued expense, a corresponding payable must be created to account for the credit side of the transaction. The accounting entry to record accrued expense will therefore be as follows:

Debit                            Expense (Income Statement)

Credit                           Expense Payable (Balance Sheet)

Example

ABC LTD pays loan interest for the month of December 2014 of $10,000 on 3rd January 2015. ABC LTD has an accounting year end of 31st December 2014. ABC LTD will recognize interest expense of $10,000 in the financial statements of year 2014 even though it was paid in the next accounting period as it relates to the current period. Following accounting entry will need to be recorded to account for the interest expense accrued:

Debit                            Interest Expense          $10,000

Credit                           Interest Payable           $10,000

On the date of payment of interest (i.e. 3rd January of the next year) following accounting entry will need to be recorded in the subsequent year:

Debit                            Interest Payable           $10,000

Credit                           Cash                            $10,000

Accrued Income

Accrued income is income which has been earned but not yet received. Income must be recorded in the accounting period in which it is earned. Therefore, accrued income must be recognized in the accounting period in which it arises rather than in the subsequent period in which it will be received.

As income will be credited to record the accrued income, a corresponding receivable must be created to account for the debit side of the transaction. The accounting entry to record accrued income will therefore be as follows:

Debit                                        Income Receivable (Balance Sheet)

Credit                                       Income (Income Statement)

Example

ABC LTD receives interest of $10,000 on bank deposit for the month of December 2014 on 3rd January 2015. ABC LTD has an accounting year end of 31st December 2014.

ABC LTD will recognize interest income of $10,000 in the financial statements of year 2014 even though it was received in the next accounting period as it relates to the current period. Following accounting entry will need to be recorded to account for the interest income accrued:

Debit                            Interest Income Receivable                  $10,000

Credit                           Interest on Bank Deposit (Income)      $10,000

On the date of receipt of interest (i.e. 3rd January of the next year) following accounting entry will need to be recorded in the subsequent year:

Debit                            Bank                                                    $10,000

Credit                           Interest Income Receivable                  $10,000

Prepaid Expense and Income

Prepaid Expense

Prepaid expense is expense paid in advance but which has not yet been incurred. Expense must be recorded in the accounting period in which it is incurred. Therefore, prepaid expense must be not be shown as expense in the accounting period in which it is paid but instead it must be presented as such in the subsequent accounting periods in which the services in respect of the prepaid expense have been performed. Entity should therefore recognize an asset in respect of expense it has paid in advance until such time as the services that are due in relation to the prepaid expense have been performed by the suppliers/contractors. Following accounting entry is required to account for the prepaid expense:

Debit                            Prepaid Expense (Asset)

Credit                           Cash

Example

ABC LTD pays advance rent to its landowner of $10,000 on 31st December 2014 in respect of office rent for the following year.

ABC LTD has an accounting year end of 31^st December 2014. ABC LTD will recognize an asset of $10,000 in the financial statements of year 2014 in respect of the prepaid expense to recognize its right to use office space in the following year. Following accounting entry will be recorded in the books of ABC LTD in the year 2014:

Debit                            Prepaid Rent                            $10,000

Credit                           Cash                                        $10,000

The prepaid expense will be recognized as expense in the next accounting period to which the rental expense relates. Following accounting entry will be recorded in the year 2015:

Debit                            Rent Expense (Income Statement)       $10,000

Credit                           Prepaid Rent                                        $10,000

Prepaid Income

Prepaid income is revenue received in advance but which is not yet earned. Income must be recorded in the accounting period in which it is earned. Therefore, prepaid income must be not be shown as income in the accounting period in which it is received but instead it must be presented as such in the subsequent accounting periods in which the services or obligations in respect of the prepaid income have been performed. Entity should therefore recognize a liability in respect of income it has received in advance until such time as the obligations or services that are due on its part in relation to the prepaid income have been performed. Following accounting entry is required to account for the prepaid income:

Debit                            Cash/Bank

Credit                           Prepaid Income (Liability)

Example

ABC LTD receives advance rent from its tenant of $10,000 on 31st December 2014 in respect of office rent for the following year. ABC LTD has an accounting year end of 31^st December 2014.

ABC LTD will recognize a liability of $10,000 in the financial statements of year 2014 in respect of the prepaid income to acknowledge its obligation to make the office space available to the tenant in the following year. Following accounting entry will be recorded in the books of ABC LTD in the year 2014:

Debit                            Cash                                                    $10,000

Credit                           Prepaid Rent Income (Liability)                       $10,000

The prepaid income will be recognized as income in the next accounting period to which the rental income relates. Following accounting entry will be recorded in the year 2015:

Debit                            Prepaid Rent Income (Liability)                       $10,000

Credit                           Rent Income (Income Statement)         $10,000

Cash Flow Statement

Introduction to Cash Flow Statement

The statement of cash flows is one of the main financial statements. (The other financial statements are the balance sheet, income statement, and statement of stockholders' equity.)

The cash flow statement reports the cash generated and used during the time interval specified in its heading. The period of time that the statement covers is chosen by the company. For example, the heading may state "For the Three Months Ended December 31, 2015" or "The Fiscal Year Ended September 30, 2015".

The cash flow statement organizes and reports the cash generated and used in the following categories:

What Can The Statement of Cash Flows Tell Us?

Because the income statement is prepared under the accrual basis of accounting, the revenues reported may not have been collected. Similarly, the expenses reported on the income statement might not have been paid. You could review the balance sheet changes to determine the facts, but the cash flow statement already has integrated all that information. As a result, savvy business people and investors utilize this important financial statement.

Here are a few ways the statement of cash flows is used.

1. The cash from operating activities is compared to the company's net income. If the cash from operating activities is consistently greater than the net income, the company's net income or earnings are said to be of a "high quality". If the cash from operating activities is less than net income, a red flag is raised as to why the reported net income is not turning into cash.
2. Some investors believe that "cash is king". The cash flow statement identifies the cash that is flowing in and out of the company. If a company is consistently generating more cash than it is using, the company will be able to increase its dividend, buy back some of its stock, reduce debt, or acquire another company. All of these are perceived to be good for stockholder value.
3. Some financial models are based upon cash flow.

General Assumptions about cash:

• When an asset (other than cash) increases, the Cash account decreases.
• When an asset (other than cash) decreases, the Cash account increases.
• When a liability increases, the Cash account increases.
• When a liability decreases, the Cash account decreases.
• When owner's equity increases, the Cash account increases.
• When owner's equity decreases, the Cash account decreases.

Accrual Basis Of Accounting

The accounting method under which revenues are recognized on the income statement when they are earned (rather than when the cash is received). The balance sheet is also affected at the time of the revenues by either an increase in Cash (if the service or sale was for cash), an increase in Accounts Receivable (if the service was performed on credit), or a decrease in Unearned Revenues (if the service was performed after the customer had paid in advance for the service).

Under the accrual basis of accounting, expenses are matched with revenues on the income statement when the expenses expire or title has transferred to the buyer, rather than at the time when expenses are paid. The balance sheet is also affected at the time of the expense by a decrease in Cash (if the expense was paid at the time the expense was incurred), an increase in Accounts Payable (if the expense will be paid in the future), or a decrease in Prepaid Expenses (if the expense was paid in advance).

Introduction to Accounting Basics

Accountancy is the process of communicating financial information about a business entity to users such as shareholders and managers (Elliot, Barry & Elliot, Jamie: Financial accounting and reporting).

Accounting has been defined as:

the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof.(AICPA)

Users of Accounting Information - Internal & External

Accounting information helps users to make better financial decisions. Users of financial information may be both internal and external to the organization.

Internal users (Primary Users) of accounting information include the following:

1. Management: for analysing the organization's performance and position and taking appropriate measures to improve the company results.
2. Employees: for assessing company's profitability and its consequence on their future remuneration and job security.
3. Owners: for analysing the viability and profitability of their investment and determining any future course of action.

Accounting information is presented to internal users usually in the form of management accounts, budgets, forecasts and financial statements.

External users (Secondary Users) of accounting information include the following:

1. Creditors: for determining the credit worthiness of the organization. Terms of credit are set by creditors according to the assessment of their customers' financial health. Creditors include suppliers as well as lenders of finance such as banks.
2. Tax Authorities: for determining the credibility of the tax returns filed on behalf of the company.
3. Investors: for analyzing the feasibility of investing in the company. Investors want to make sure they can earn a reasonable return on their investment before they commit any financial resources to the company.
4.  Customers: for assessing the financial position of its suppliers which is necessary for them to maintain a stable source of supply in the long term.
5. Regulatory Authorities: for ensuring that the company's disclosure of accounting information is in accordance with the rules and regulations set in order to protect the interests of the stakeholders who rely on such information in forming their decisions.

External users are communicated accounting information usually in the form of financial statements. The purpose of financial statements is to cater for the needs of such diverse users of accounting information in order to assist them in making sound financial decisions.

Accountancy encompasses the recording, classification, and summarizing of transactions and events in a manner that helps its users to assess the financial performance and position of the entity. The process starts by first identifying transactions and events that affect the financial position and performance of the company. Once transactions and events are identified, they are recorded, classified and summarized in a manner that helps the user of accounting information in determining the nature and effect of such transactions and events.

Accounting is a very dynamic profession which is constantly adapting itself to varying needs of its users. Over the past few decades, accountancy has branched out into different types of accounting to cater for the different needs of the users.