When you’re running a business, it’s critical to keep your records straight. Two of the most important processes for any business are accounts payable (AP) and accounts receivable (AR), which allow you to keep track of the money that you owe to others and that others owe to you. It’s important to understand the difference between these two, since one is considered an asset to your company, and the other a liability. Having a good grasp on the processes tied to each will help ensure your business’ finances are in order.
In this article, we’ll take you through the basic differences between accounts payable and accounts receivable, and explain how each works in greater detail. Then we’ll explain the benefits of having a good AP and AR setup, and our tips for improving your AP and AR processes.
• The Basics: Accounts Payable and Accounts Receivable
• What’s the Difference Between Accounts Payable and Accounts Receivable?
– How Does Accounts Payable Work?
– How Does Accounts Receivable Work?
• What Are the Benefits of Accounts Receivable and Accounts Payable
• Improving Your Accounts Payable and Accounts Receivable Processes
The Basics: Accounts Payable and Accounts ReceivableBefore we get into the differences between accounts payable and accounts receivable, let’s start with the basics and quickly define each. Accounts payable is the record of money that your business owes third parties, like for services contracted or goods purchased by your company. Accounts receivable, on the other hand, is the record of money that other parties, like your clients or customers, owe to the business.
What’s the Difference Between Accounts Payable and Accounts Receivable?
Accounts payable and accounts receivable are similar in that they both represent money owed, but the key difference between the two is to whom that money is owed.
As we saw in the definitions in the previous section, accounts payable is the record of money that your company owes other parties, while accounts receivable is the record of money that your company is owed by other parties. It’s important to keep these straight, since the balance in accounts payable is a liability to the business, while the balance in accounts receivable is an asset.
The processes for AP and AR mirror each other in their basic steps. Both typically involve processing invoices or receipts for line items, plus processing of incoming or outgoing payments. But let’s get into how each of those processes work in more detail to learn about their differences.
How Does Accounts Payable Work?
A company will use accounts payable any time it needs to make a payment to someone outside the business. This could be for services contracted or goods purchased, and it’s typically used for all expenses other than internal payroll.
Before getting started, it’s important to have all the proper information on file for each vendor, like name, billing address, contact information, and any other information that might be used internally, like a vendor ID. Once you have all of that information on hand, you’ll need to run through the following steps of the accounts payable process:
1. PURCHASE ORDER
A purchase order is the first important document to have on file—physically or digitally—for any transaction. It’s a record of information like the date, quantity, price, terms, and vendor information for an order.
2. GOODS RECEIPT
A goods receipt, also called a receiving report, is what’s supplied alongside a delivery. It’s like a glorified packing slip. At this stage, it’s important to check the goods receipt against what was actually received, in case there are any discrepancies.
3. VENDOR INVOICE
After a vendor has filled an order, or a client has provided a service, they’ll send an invoice. An invoice is an official request for payment and will specify the amount due, including any sales tax and shipping fees. The invoice may also include information on how to pay and the payment due date.
4. THREE-WAY MATCH
The next step for proper bookkeeping is to do what’s called a three-way match, which compares the purchase order, goods receipt, and vendor invoice to ensure the details are the same across all three. This step ensures the accuracy of records, the accuracy of your payment, and can prevent trouble, including fraud, down the line.
5. PAYMENT PROCESSING
Most businesses use an additional approval process at this step, where someone formally approves each invoice as ready for payment. Some businesses may do this manually, but increasingly, businesses are turning to automation to streamline the process. For instance, some invoice approval software allows for a tiered approval system; if someone is out of the office, the request for approval can automatically reroute to the second in command.
During each of these steps, it’s important to keep careful records of important documents and make sure the necessary information is recorded by the accounts payable team. For instance, you might digitize invoices using Optical character recognition (OCR) technology, which automatically converts information in scanned documents into text, and saves employees from entering information from print copies manually.
How Does Accounts Receivable Work?
Accounts receivable is a similar process as accounts payable, except now you’re the vendor who is owed compensation for the goods or services you provided a third party. Just like with accounts payable, you’ll want to be sure you have all the information on file for each customer or client, like name, billing address, contact details, and any other information that might be used internally, like a customer ID.
Once you’re set with client information, you’re ready to walk through the steps of accounts receivable.
1. ESTABLISH A CREDIT SYSTEM
First, decide which individuals or businesses are dependable enough to receive their goods or services from you before paying. Then, determine the terms and conditions for credit sales. How long will customers have to pay? How much interest will you charge for late payments? It’s important to communicate this information to customers at the outset, and be aware of how timing of payments will affect your business’ cash flow.
2. CUSTOMER INVOICE
Once your system is established and you’ve provided goods or services to a customer or client, it’s time to send an invoice. Just like the invoices you’d receive from vendors, this document is an official request for payment and outlines the goods or services provided, the amount due, the payment due date, and the terms for late payments. Your business might also offer discounts for early payment.
3. TRACKING PAYMENTS
It’s important that a business keeps track of payments received. Typically an accountant or an accounts receivable officer will be tasked with making sure all invoices are paid, and all payments are posted in the business’s account. Clients and customers paying late may need additional follow-up to secure payment.
4. ACCOUNTING FOR AR
Once the process is complete, the accountant or AR officer will finish the transaction by making a record in the accounts receivable ledger. This step is often automated in more modern accounts receivable systems.
What Are the Benefits of Accounts Receivable and Accounts Payable?
Now that you know what accounts receivable and accounts payable are, and how each process works, let’s discuss the benefits of AR and AP and why they matter to businesses.
- Saves money Good recordkeeping in accounts payable will help your business avoid late payments, which can save money by avoiding late fees.
- Provides a flexible cashflow Properly kept accounts receivable will ensure that cash flow stays within your control, allowing your business to be more flexible when it comes to expenses.
- Supports strong business relationships Well-run accounts receivable and accounts payable help maintain good relationships with vendors and clients. When people are paid on time, and in the right amounts, everyone is better off.
Improving Your Accounts Payable and Accounts Receivable Processes
Though accounts payable and accounts receivable might seem confusing at first, they’re really just two sides of the same coin. However, the processes behind each are distinct and critical to any business. And with the amount of paperwork involved in these processes, staying organized can quickly become a challenge especially if you’re still handling documents manually.
Companies like MHC provide solutions that can digitize and streamline any accounts payable and accounts receivable department. Features like top-notch OCR; automated, tiered approval routing; and self-serve portals reduce errors and save everyone—from your team to your clients and vendors—precious time and money. Want to learn more? Check out MHC’s solutions for your AP department today.