Understanding Accounts Payable: The CFO’s Complete Guide

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Thursday, March 10, 2022

The accounts payable (AP) team is responsible for maintaining a positive cash flow and building strong and ongoing supplier relationships. Despite this, their role within the business is often undervalued and misunderstood.

Article 10 Minutes
Understanding Accounts Payable: The CFO’s Complete Guide

In today’s ever-changing business landscape, it’s in your best interest to understand as much as you can about the day-to-day functions and processes that take place across the accounting and finance department and this includes accounts payable.

In this comprehensive guide, we will help you to build your knowledge of this crucial accounting department, making it much easier for you to run a financially stable and competitive organization.

  1. What is accounts payable?
  2. How does accounts payable work?
  3. Accounts payable vs. accounts receivable
  4. 6 examples of accounts payable
  5. The challenges of accounts payable
  6. How can the accounts payable process be improved?
  7. Automating your accounts payable
  8. What is accounts payable turnover ratio?
  9. How can you calculate accounts payable turnover ratio?
  10. Final thoughts

What is accounts payable?

Accounts payable (AP) is the term used to describe any amount of money that’s owed to vendors or suppliers for their goods or services that your organization has purchased on credit.

The sum of these outstanding payments is recorded on the company’s balance sheet each month, quarter or year, depending on how often these are created. Since it is money owed to creditors, it’s listed under the current liabilities section.

That said, any increase or decrease in a company’s total accounts payable figure over the same period will appear on the company’s cash flow statement, not the balance sheet. More specifically, when using the indirect method to prepare the cash flow statement, the increase or decrease in accounts payable will appear in the top section.

How does accounts payable work?

The accounts payable process is an important part of accounting. However, it’s not as simple as just making a couple of payments.

With money flowing in and out all the time, it’s important to maintain close internal controls and processes to avoid overpaying or settling inaccurate invoices.

As such, a well-run and very organized accounts payable process is crucial to the company’s bottom line.

Processing accounts payable

In order to keep things running smoothly, the AP process is broken down into five smaller steps. These include:

  1. Invoice capture: The first step is receiving the invoice from the supplier or vendor.
  2. Invoice approval: The accounting team must then verify with the relevant team or colleague that the goods or services were received and that the invoice is accurate and OK to be approved.
  3. Dealing with errors: If there are any variances or mistakes in the invoice, such as the wrong quantity or price, the buyer must find the source of the issue and rectify this before having an updated invoice sent to the AP team.
  4. Payment authorization: Once all checks have been made and the invoice is correct and ready, the team gets authorization to set up and make the payment.
  5. Making payment: The payment is then made, and the vendor or supplier is made aware of this. Finally, the invoice is marked as ‘paid’ in your chosen finance system.

How to record accounts payable

Knowing how and when to record accounts payable is vital for ensuring a smooth AP process.

When recording an account payable, the accountant must credit AP as soon as the invoice is received from the vendor or supplier.

When this AP debt is paid, the accountant must debit accounts payable to decrease the liability figure on the balance sheet.

Accounts payable vs. accounts receivable

As well as understanding accounts payable, it's beneficial to recognize another common phrase, accounts receivable, and the differences between the two.

As mentioned above, accounts payable refers to the sum of money owed to suppliers or vendors for goods or services bought on credit.

Accounts receivable (AR), on the other hand, refers to any money that’s owed to your organization for goods or services you’ve provided to your customers or clients on credit.

This figure is considered an asset and is, therefore, found under the assets section of the companys balance sheet.

6 examples of accounts payable

Accounts payable is listed as a business liability, but these differ from other liabilities, such as short-term loans, accruals or bank account overdrafts. To give a little more context as to what AP debts are, here are six examples:

  • Raw materials: If your company requires raw materials to make its products, for example, wood or steel, a supplier will be required to provide you with these materials. The invoice from the subsequent supplier will go down as accounts payable.
  • Products and equipment: If you lease or purchase equipment that allows you to offer your goods or services, this falls under AP. This also includes the purchasing of products for sale or to use when offering your services.
  • Leasing: We’ve mentioned equipment, but you might also be leasing office space or vehicles.
  • Transportation and logistics: Although you might not think it, debts for transportation, logistics or freights will also fall under accounts payable as this is a service provided by a third-party.
  • Services: If you use subcontractors for any reason within your business, for example, doing some maintenance or repairs work on the office building, it’s considered accounts payable as you will be paying them for their services
  • Licensing: There are occasions when licensing fees can fall within the AP category – for instance, if your company often requires licenses for software such as Microsoft Office.

The challenges of accounts payable

Most companies have plenty of accounts payable tasks being undertaken every day, particularly within larger organizations. Despite this, AP teams often face multiple challenges on a daily basis. Some of the key obstacles they’re up against include: 

1. Slow processing

Having to manually process invoices and paper-based documents can be very time-consuming, slowing down the overall AP process. Falling behind or taking a long time to make a payment can lead to poor relationships with suppliers, as well as late fees.

2. Matching errors

As mentioned above, the AP process requires the team to run some matching checks and get approval on all invoices before paying them. Any invoice discrepancies can slow the process down drastically as the correct information and documents must be secured before payment can go ahead.

3. Missing invoices

In a mountain of paperwork or possibly even emails, its all too easy for invoices to go missing. Besides this causing problems with suppliers, if not rectified quickly it can also leave the balance sheet and income statement inaccurate. This means that management will be presented with erroneous information about the companys current financial position.

4. Fraud and theft

Unfortunately, many organizations will lose some of their revenue each year to fraud or theft. As such, AP teams must always be on the lookout for false invoices or any other type of accounts payable fraud.

5. Double payments

Manual data entry and slow processing times can cause a number of problems, but one of the biggest is double payments. Inconsistencies in data entry can cause a single invoice to be paid twice. This leaves AP teams having to chase up suppliers to get the money back or causing issues with the next month’s accounts payable.

How can the accounts payable process be improved?

Addressing the problems outlined above can seem like a daunting task for any organization, but there is good news.

Between technology and getting finely-tuned systems in place, you can make improvements to streamline your accounts payable process. These might include:

  • Standardizing processes such as handling and checking invoices - this will reduce the risk of errors like missing invoices
  • Getting effective payment systems in place - making the most of ERP, AP automation tools and accounting software systems
  • Archiving your information carefully and effectively as soon as a payment has been made
  • Keeping your departmental budget organized and up to date
  • Forecasting accounts payable on your balance sheets to predict payment patterns and take advantage of incentives such as early payment discounts
  • Using laser printed checks if possible to reduce the risk of hand-written errors and help prevent fraud
  • Strategically delaying payment or making partial payments if needed

This list isn’t exhaustive, but these are some of the best ways to improve your accounts payable processes and systems.

Automating your accounts payable

Automation has dramatically transformed accounts payable processes over the past few decades, making what used to be a labor and time-intensive role full of risks a much safer and quicker process.

Research from Tipalti shows 20% of teams have already embraced automation, and 41% are planning to automate their processes within 12 months.

Some of the key benefits of using AP automation are that it frees up the time of your accountants to focus on more important tasks, reduces the risk of error and improves business relationships.

Automation also allows you to get a strong accounts payable reconciliation process in place, in which AP teams can quickly and easily compare different sets of financial records to ensure everything is as it should be. This ensures more accurate balance sheets and reduces the risk of an error occurring.

Learn more: 3 Obstacles to Overcome When Implementing AP Automation

What is accounts payable turnover ratio?

Another important phrase you should know as a CFO is accounts payable turnover ratio. This ratio refers to how quickly your business makes payments to its creditors and suppliers over a set period of time (yearly or monthly, for example).

On the companys balance sheet, the accounts payable turnover ratio acts as an indicator of how well your organization is managing its cash flow.

How can you calculate accounts payable turnover ratio?

When it comes to calculating the accounts payable turnover ratio, there is a set formula that can be used and this requires two stages.

First, the accounting team must find the average accounts payable balance. This is done by adding the sum of accounts payable at the beginning and end of a set period and dividing it by two, like this:

(Sum of accounts payable at the beginning + sum of accounts payable at the end) / 2 = Average accounts payable balance

They can then divide the companys total purchases by the companys average accounts payable balance over the same period to find the AP turnover ratio, like this:

Total purchases / Average accounts payable balance = Accounts payable turnover ratio

Final thoughts

The accounts payable process has traditionally been a labor-intensive activity that requires a lot of manual work. It also existed to serve the organizations supply-based needs and to meet its financial obligations to suppliers, those created by other departments.

However, although its core function still remains the settling of outstanding debts owed to suppliers, the AP function can also generate real value for the company in terms of forecasting and providing accurate financial data and insights.

By getting a strong account payable process in place and making the most of ERP and automation tools, accounting teams can overcome some of the challenges they face on a daily basis and effectively streamline the companys AP process, helping to save time and money, and reduce the risk of errors.

By helping your team to constantly improve the AP process and get best practices in place, you can better support the organizations bottom line.

Further reading:

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