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Account Payable and Payables
Definition, Meaning Explained, Example Transactions

 

An account payable is a bill to be paid, or money otherwise owed to a creditor. Accounts payable is a liabilities account, representing all such payables due for payment in the near term.

Does the firm manage its accounts payable obligations effectively? Financial metrics such as Accounts Payable Turnover provide an answer.

What Is An Account Payable?

An account payable is a liability for an amount owed to a creditor, usually for purchase of goods or services.

Consider a buyer who makes a purchase and takes delivery of the goods, but does not pay the seller immediately. The seller is therefore selling "on credit." As a result, buyer and seller now have a creditor-debtor relationship. And, the relationship lasts until the buyer actually pays.

The buyer's accounting system recognizes the short term debt as an account payable. This debt enters the buyer's system in a liabilities account, Accounts payable. The unpaid purchase price sits in Accounts payable for the life of the debt. Then, when the buyer actually pays, the Accounts payable balance decreases by the same amount.

Account Payable Explained in Context

Sections below further define, explain, and illustrate account payable. Note especially that the term appears in context with related terms and concepts, including the following:

Accounts Payable
Payables
Account Receivable
Receivables
Journal Entries
Ledger
Income Statement
Balance Sheet
Accounts Payable Efficiency
Metrics for Accounts Payable
Accounts Payable Turnover
Days Payable Outstanding

 

Contents

Related Topics

  • For more on the closely related concepts Accounts Receivable and Receivables, see the article Account Receivable.
  • See the articles Accrual Accounting for an overview of the role of accrual concepts in business commerce--from the perspective of both buyer and seller.
  • The article Double Entry System explains the role of Debit and Credit transactions in keeping track for accrued items, and for keeping the balance sheet balanced.

 

What are Payables and Receivables?

Under accrual accounting, firms track some of their debts under the name payables. Accounts payable is an example. And, they refer to some of the monies owed them as receivables, such as Accounts receivable. Note especially that both receivables and payables are legally binding obligations, owed by one party to another.

Accounts payable normally is not the totality of the firm's short term debt. Other short term debt appears in other accounts with a name including payable, such as:

  • Employee wages payable.
  • Short term notes payable
  • Loan interest payable
  • Taxes payable
  • Portion of long term debt payable this period.

The Meaning of Accounts Payable

Accounts payable is an accounting system account holding the sum of all current account payable items. Bookkeepers and accountants credit and debit Accounts payable as the firm incurs and pays off debts for buying goods and services. As a result, the current balance of this account is the sum of payables the firm currently owes to sellers.

In the accounting system, the firm's debts appear in two major categories:

  • Firstly, Accounts payable is classified as a Current Liabilities account. The term "current" means these debts are due in the short term (within a year or less).
  • Secondly, the other major liabilities account class, of course, is Long Term Liabilities. These debts are not due for complete payoff in the next year.

How Does Buying Create an Account Payable?

The Accounts payable concept applies only where firms practice accrual accounting with a double-entry accounting system. Note that in the simpler alternative approach, cash basis accounting, there are only two kinds of transactions: cash inflows and cash outflows. Companies using cash-basis accounting can of course incur debts and bills they must pay in the short term. And, they may even refer informally to these debts as "Accounts payable." Nevertheless, under cash-basis accounting, such debts are outside the accounting system until the debtor pays with cash.

By contrast, when the buyer's firm uses accrual accounting, the buyer creates an Account payable when purchasing goods or services on credit. From the time when the sale closes, seller and buyer have a creditor-debtor relationship. This relationship lasts until two events occur: Firstly, purchase delivery, and secondly, payment of the bill. As a result, during the life of the debt, both parties record and track debt-related transactions as the following sections show.

Account Payable Journal Entries

Consider a purchase by a retail merchant, Woofer Pet Supplies. On 2 September, Woofer purchases pet food merchandise inventory from its supplier, Ajax Wholesale Feed Company. Ajax charges Woofer $1,180 for the order. Woofer does not pay Ajax immediately, however. Consequently, Ajax gives Woofer an invoice marked "Payable" for that amount.

Woofer's bookkeeper or accountant therefore makes two journal entries for the purchase:

  • Woofer creates a new "account payable" and adds (credits) its value to Accounts payable. Note especially that Accounts payable is a liabilities account, and therefore its balance increases with a credit transaction.
  • The second entry required in a double-entry system is a simultaneous debit to the asset account, Merchandise Inventory. Asset account balances increase with a debit transaction.

Exhibit 1 below shows how these transactions appear in the buyer's journal.

Woofer Pet Supplies
Journal for Fiscal Year 20YY
Date Account Debit
Credit
2-Sep-20YY
2-Sep-20YY
 103  Merchandise Inventory
 200      Accounts payable
$1,180  
$1,180

Exhibit 1. The buyer purchases merchandise inventory on credit and makes two journal entries. Firstly, the buyer debits (increases) Merchandise Inventory, a Current assets account. Secondly, the buyer credits (increases) a Current liabilities account, Accounts payable.

At the same time, in the seller's back office, Ajax keeps track of the creditor-debtor relationship with two journal entries:

  • Ajax applies a $1,180 debit (increase) to one of its own asset accounts, Accounts Receivable.
  • Ajax simultaneously applies a $1,180 credit (increase) to its own Sales Revenue account.

The debt is now "on the books" in both companies.

What Happens to Accounts Payable When the Debtor Pays?

Three days later, on 5 September, Woofer uses a bank debit card to pay Ajax the full $1,180 due. As a result, Woofer's accountant makes two journal entries simultaneously:

  • The buyer (Woofer) decreases (debits) the Accounts payable balance.
  • The buyer decreases (credits) the balance in its own Current Assets account, Cash.

Exhibit 2 below shows how these transactions appear in the buyer's journal.

Woofer Pet Supplies
Journal for Fiscal Year 20YY
Date Account Debit
Credit
5-Sep-20YY
5-Sep-20YY
 200  Accounts payable
 150      Cash
$1,180  
$1,180

Exhibit 2. The buyer pays cash to cover the debt to the seller with two transactions. Firstly, the buyer debits (decreases) accounts payable, because the debit is now paid, and secondly, the buyer credits (decreases cash) for the amount of the payment.

Notice especially that both companies treat the bank card payment as a cash transaction.

On the seller's side, Ajax accountants increase (debit) their own Current asset account, Cash, and decrease (credit) another of their asset accounts, Accounts receivable. Note that the seller claims "Sales Revenues" immediately at the time of the sale. Not until the buyer actually pays, however, does the seller's new asset value flow from the seller's Accounts receivable into a Cash account.

The Buyer's Viewpoint

On the buyer's side, Woofer accountants now post these transactions to the general ledger. The ledger has a "T-account" format , showing the transaction history of each account.

A small part of Woofer's Accounts payable ledger presence might look like the T account in Exhibit 3:

 

Exhibit 3. Accountants post Accounts payable transactions from the journal to a ledger account (T-account). The T-account show the balance and all transaction activities in the Accounts payable account.

Before the purchase on 1 September, Woofer's Accounts payable balance stood at $1,700. After Woofer incurs the account payable (2 September) and then pays the $1,180 debt (5 September), the Accounts payable balance returns to $1,700.

Which financial Metrics Involve Accounts Payable?

Analysts use the company Accounts payable balance to address questions like these:

Is the company:

  • Managing to maintain sufficient liquidity to support operations and meet short term spending needs?
  • Managing its Accounts payable liabilities efficiently?
  • Accounts payable status benefitting or harming financial performance and financial position?

Financial metrics in the following sections use data from the Income statement and Balance sheet to address these questions.

Two Accounts payable Efficiency Metrics: APT and DPO

Analysts use two different metrics to measure a firm''s ability to manage cash flow and meet immediate payable obligations:

  • Accounts payable turnover APT.
    APT is a liquidity metric. The calculation returns a frequency. APT is therefore the number of times per accounting period the firm pays off its suppliers.
  • Days payable outstanding DPO
    DPO is an activity and efficiency metric.
    The DPO calculation returns a duration—a number of days. DPO is therefore the average number of days the firm takes to pay off its suppliers.

The Accounts Payable Turnover APT Metric Measures Payoff Frequency

The Accounts payable turnover APT metric uses Income statement and Balance sheet figures to measure the company's Account payable payoff performance. Note especially that APT is a frequency—the number of times per accounting period the company pays off its suppliers. Analysts call APT a liquidity metric because it measures the company's ability to manage cash flow and meet immediate needs.

An annual result of APT = 13.4 signals that the company pays off its Accounts payable bills 13.4 times per year.

Calculating Accounts Payable Turnover

APT derives from Income statement Cost of Goods Sold and Balance sheet Accounts payable. The Exhibit 4 Balance sheet and Exhibit 5 Income statement below show the source location of these data. For this example:

Cost of Goods Sold = $22,043,000
Accounts payable = $1,642,000

From these input data, Accounts payable turnover calculates as a ratio:

APT = Cost of Goods Sold / Accounts payable
        = $22,043,000 / $1,642,000
        = 13.4 payoffs / year

What Does the APT Result Mean?

An APT result of 13.4 means the firm pays off its suppliers about monthly, or a little faster. That is not surprising in a business environment where most creditors require payment "net 30 days" from receipt of invoice.

One might think that a rule for APT would be simply "the higher the better." However, financial officers will probably disagree with that rule.

  • A very high APT rate could mean that the firm is having trouble obtaining credit.
  • A very high APT rate could also mean that the firm is not making good use of funds (e.g., not holding onto funds that could otherwise be earning interest before payoff).

Analysts agree, however, that a much lower APT result, such as 3 - 5 payoffs per year is certainly a negative result.

  • A very low APT rate could mean that the firm's creditors are extending unusually long credit terms, such as "net 60 days.
  • A very low APT could also mean, simply, that the firm is overdue paying its bills.

Days Payable Outstanding DPO Metric Measures Payoff Duration

The APT metric is a frequency, the number of payoffs per period. Analysts also refer to another metric that measures approximately the same thing as APT, but expresses the result as a duration. Days payable outstanding DPO is, in other words, a measure of time, the average number of days per payoff. A DPO result of DPO = 27.2 means that the firm takes requires an average 27.2 days to pay off its suppliers.

Analysts also to another metric that measures approximately the same thing as APT, namely days payable outstanding or DPO. While APT is a frequency, DPO is a number of days.

Calculating Days Payable Outstanding

The activity and efficiency metric, Days payable outstanding (DPO) uses the same input data as the liquidity metric, APT: Firstly, Cost of Goods Sold from the Income statement and secondly, Accounts payable from the Balance sheet. Alternatively, DPO can be found simply as the APT result divided by the number of days per period.

Using Cost of Goods Sold and Accounts payable figures from Exhibits 4 and 5, the DPO input data are as follows:

Cost of Goods Sold = $22,043,000
Accounts payable = $1,642,000

Accounts payable turnover APT calculates as a ratio:

DPO = Number of days * (Accounts payable / Cost of Goods Sold)
          = 365 * ($1,642,000 / $22,043,000)
          = 27.2 days

Also, using instead the APT figure from above as input, DPO calculates as:

DPO = Number of days / APT
= 365 / 13.4
= 27.2 days 

What Does the DPO Result Mean? Where Should You Use DPO Instead of APT?

  • When focusing on using resources efficiently, the DPO activity and efficiency metric version of this information is more helpful.
  • When focusing on the company's liquidity, the APT frequency version is more helpful, even though both metrics carry exactly the same information.

Which Other Financial Metrics Reflect the Accounts Payable Balance?

Other financial metrics also reflect the Accounts payable debt. In these metrics, however, Accounts payable plays a lesser role than it does in APT and DPO.

Other Liquidity Metrics Involving Accounts Payable

Several other liquidity metrics use the Balance sheet figures for Current Assets and Current Liabilities. As a Current liability, Accounts payable also contributes to these metrics.

     • Working capital
     • Current ratio
     • Acid-test ratio

Other things being equal, the larger the Accounts payable component, the lower the firm's liquidity "score." Working capital, for instance, is the following difference:

Working capital = Current assets – Current liabilities

Obviously, a larger Accounts payable means larger Current liabilities and therefore less working capital.

For more on these liquidity metrics and example calculations, see the Encyclopedia article Liquidity Metrics.

Leverage Metrics Involving Accounts Payable

Two frequently used leverage metrics also reflect Current Liabilities debt, including Accounts payable:

     • Total debt to assets ratio (debt ratio)
     • Total debt to equities ratio

 

Other things being equal, the larger the firm's Accounts payable balance, the higher its leverage score. For more on leverage metrics and example calculations, see Leverage Metrics.

What is the Role of Accounts Payable in the Company's Financial Structure?

Company funding results primarily from two kinds of sources: owners and creditors. Owner supplied funds are the firm's Equities, while Creditor supplied funds are the firm's liabilities. For some companies, owners provide the majority of funding, while for others creditors provide most. As a result, the balance of funding between these two sources is a measure of the firm's level of leverage. And leverage, in turn, describes how owners and creditors share business risks and rewards.

Two structures within the company's Balance sheet define the company's level of leverage: Financial structure and Capital structure. Note especially that Accounts payable and other short term debt:

  • Are part of the firm's financial structure.
  • Are not part of the firm's capital structure.

Financial structure compares the relative magnitudes of various Balance sheet liabilities and equities. For a highly leveraged company, therefore, lender-supplied funds (liabilities) are large relative to owner supplied funds (equities).

  • In a healthy economy, when business volume is strong and inflation is under control, companies benefit from high leverage. This is because they earn more with borrowed funds than they pay for debt service.
  • The reverse is true when the economy is weak and business is poor. Consequently, in that case, a high leverage company spends more on debt service than it earns from using borrowed funds.

For quantitative examples, see the article Capital and Financial Structure.

Capital Structure vs. Financial Structures

A company's financial structure differs from its capital structure (capitalization) only in that financial structure includes short term liabilities, while capital structure does not.

  • Metrics that measure leverage under financial structure (such as the total debt to equities ratio mentioned above) result in higher leverage ratings when Accounts payable is larger.
  • A highly leveraged business benefits from its debt when sales are strong and the economy is healthy. However, the debt burden penalizes the business, instead, when sales and the economy are weak.

Where Does Accounts Payable Appear on the Balance Sheet?

Accounts payable appears on the Balance sheet under Current liabilities, along with other short-term debts. On the end-of-period Balance sheet, Accounts payable shows the sum of all accounts (still) payable, as Exhibit 4 shows.

Exhibit 4. Example Balance sheet showing Accounts payable under Current Liabilities.

Where input data for Accounts payable metrics Appear on Income statement?

Some of the Accounts payable financial metrics above draw input data from the Income statement in Exhibit 5, below.

Exhibit 5. Example Income statement showing Cost of Goods Sold, used as input for Accounts payable metrics.

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