- Define accounts payable and differentiate from other payables
A bill or invoice from a supplier of goods or services on credit is often referred to as a vendor invoice. The vendor invoices are entered as credits in the Accounts Payable account, thereby increasing the credit balance in Accounts Payable. When a company pays a vendor, it will reduce Accounts Payable with a debit amount. As a result, the normal credit balance in Accounts Payable is the amount of vendor invoices that have been recorded but have not yet been paid. The unpaid invoices are sometimes referred to as open invoices.
We covered trade accounts payable in some depth in the module on inventory purchases using this invoice:And we created this journal entry to record the receipt of inventory and the invoice under a perpetual inventory system using the gross method:
| Date | Description | Post. Ref. | Debit | Credit |
|---|---|---|---|---|
| 20XX | ||||
| Dec 19 | Inventory | 20,7000 | ||
| Dec 19 | Accounts Payable | 20,700.00 | ||
| Dec 19 | To record purchase of XPS-101 from Bryan Whls 200 count |
We could also record this invoice using the net method. Notice when we are speaking about invoice terms, the “net 30” actually means you end up paying the full amount of $20,700, but when we are talking about recording an invoice, the net method refers to the amount of the invoice net of (minus) the discount. That’s because in the legal world of trade credit, “net” means the invoice amount after returns and allowances, whereas in the accounting department, “net” in this case means net of the discount. The word means the same thing in both lexicons, but are being applied differently. In any case, recording the invoice net of the discount looks like this under a perpetual system:
| Date | Description | Post. Ref. | Debit | Credit |
|---|---|---|---|---|
| 20XX | ||||
| Dec 19 | Purchases | 20,300.00 | ||
| Dec 19 | Accounts Payable | 20,300.00 | ||
| Dec 19 | To record purchase of XPS-101 from Bryan Whls 200 count less $400 discount |
Notice we compute the discount on the invoiced amount of product, not including freight. The items were shipped FOB shipping point, which means the buyer (Geyer Company) is responsible for shipping costs since legal title transferred when the product left the seller’s shipping dock (the transporter is our agent). That means the discount is $400. The total discounted invoice amount for the purchase is then $19,600 plus freight of $700 = $20,300.
In summary:
- On the invoice, “net 30” means pay the total amount due, net of any returns or allowances, in 30 days.
- In recording, the “net method” means to record the invoice net of the discount.
Under the gross method of recording an invoice, if the discount is not taken, there is no entry other than a credit to the checking account for $20,700 and a debit to accounts payable that wipes out the amount due to Bryan on both the general ledger and the subsidiary ledger.
Under the net method, if the discount is not taken, the company would make an entry like this:
The entry is as you might expect it to be:
| Date | Description | Post. Ref. | Debit | Credit |
|---|---|---|---|---|
| 20X1 | ||||
| January 20 | Accounts Payable | 20,300.00 | ||
| January 20 | Discounts Lost | 700.00 | ||
| January 20 | Checking Account | 20,700.00 | ||
| January 20 | To record payment of Bryan invoice #1258 after the discount date |
In this case, we recorded the payable net of the discount, but we had to pay the gross amount (which is called “net” on the invoice, but remember it means net of returns and allowances). So, we credit the checking account for the payment, debit accounts payable for the net amount of the invoice, and the difference becomes an expense that is roughly equivalent to interest expense because we did not pay the invoice promptly–we financed the purchase for a very short period of time (20 days or so). If you annualize that interest rate, it comes out to approximately 36.5%. This is why companies set up short-term notes payable (such as a revolving line of credit with the bank). Paying a small bit of interest on a bank note is far cheaper than racking up lost discounts. This is the advantage of recording invoiced net of the discount–your company can track the cost of missing the prompt payment window.
Under the gross method, if your company pays within the discount period (10 days in this case), the entry is as you might expect it to be:
| Date | Description | Post. Ref. | Debit | Credit |
|---|---|---|---|---|
| 20XX | ||||
| Dec 29 | Accounts payable | 20,700.00 | ||
| Dec 29 | Inventory | 400.00 | ||
| Dec 29 | Checking account | 20,300.00 | ||
| Dec 29 | To record payment on invoice #1258 from Bryan Whls |
Under the perpetual system, the cost of the inventory items would be reduced to reflect the discount taken. The checking account is reduced by the amount of the check written that includes the $19,600 discounted purchase price and $700 in freight. Accounts payable was recorded at the amount shown on the invoice (“gross” to accountants, “net” to purchasing folk) and was reduced to reflect the account paid in full.
Under the periodic system, instead of posting the $400 credit to inventory, it would be posted to an account called purchase discounts.
Other kinds of payables include wages payable, dividends payable, short-term notes, and any other liability that arises during the normal course of business but is not classified as an official “accounts payable”, and that classification is largely up to the accountants, although, in general, purchases of inventory and normal bills like rent, electricity, phone, supplies, and even insurance could be included in accounts payable.
You may now be wondering how the subsidiary ledger for Accounts Payable and the General Ledger are recorded? We’ll cover that next.