If you have done accounting for your business, you might have heard about accounts payable and accounts receivable. In most cases, you might have also gone through the confusion of mistaking one for the other.
Accounts payable and accounts receivable are two types of accounts similar in how they are recorded. However, it’s essential to differentiate one from the other. You need to be able to tell the difference between accounts payable vs. accounts receivable. The reason is that one account receives assets while the other receives liabilities.
Mistaking one from the other can result in a lack of balance in your accounting equation that can potentially carry over your basic financial statements. That’s why you must acknowledge the importance of balancing your assets and liabilities and stockholders’ equity in accounting.
In this article, we’re going to do just that to help you understand the differences and significance of both accounts receivable and payable. This basic accounting equation can explain the significance of the balance:
Assets = Liabilities + Stockholder’s Equity
You can rearrange the equation to suit your preferences better.
Before we move further, let’s first define what accounts payable and accounts receivable are.
What is Accounts Payable?
Accounts payable involves the current liability account that keeps track of money that you owe to any third party. Third parties can be companies, banks, or even someone whom you owe money from. A common type of accounts payable is a mortgage accounts payable. When you decide to take out a mortgage, you will sign a contract that states you paying the loan back over a period of time (installments).
What is Accounts Receivable?
Receivable accounts are current asset accounts that keep track of the money that any third party owes you. As said earlier, these third parties can be other companies, banks, or even people who borrowed money from you. An example of an account receivable is an interest receivable that you get from making investments or putting cash into interest-bearing savings account from your bank.
How To Record Accounts Payable
Many times, companies purchase items on account (not in cash). The term “on account,” should indicate a transaction where cash isn’t involved. To put it into perspective, here’s an example:
On August 1, 2020, Business A purchased $5,000 worth of construction equipment on account from Construction Company. It means that the asset account, which is a piece of construction equipment, increased and the liability account, which is the accounts payable, also increased by $5,000. If placed in a journal entry, this is what it would look like:
How To Record Accounts Receivable
There are times when a company will offer goods or services on account. That means transactions are occurring where cash isn’t involved. However, this time, you’re on the receiving end. Here’s an example to help you visualize what it will look like:
On August 2, 2020, Computer Equipment Company sold $2,500 worth of computer equipment on account to Business B. In the transaction, the accounts receivables increased by $2,500, and the computer equipment account decreased by $2,500. Again, if placed in a journal or balance sheet, this is what it would look like:
Another important aspect between accounts payable and receivable accounts is discounts. There will be instances when a company will attach discounts to accounts payable vs. accounts receivable. The discount will serve as an incentive for the borrower to pay back the amount earlier to receive the discount.
Discounts benefit both parties because the borrower will receive the discount while the company receives their cash repayment at an earlier period. As the company, you require cash for your operating activities. So, getting paid earlier is good since you can use the money for your business.
Notations for Discounts
For discounts to be effective, notations need to be used. Here are two commonly used notations that you should be aware of:
- x/10 or x/20, where “x” indicates any number between 1 and 4).
The first notation is read as x percentage discount if the amount owed is paid back or received within 10 days. Some companies even give discounts if the current liability is paid before or received within 20 days. For example, a 5% discount that’s paid within 20 days would be 5/20.
The second notation is commonly used after the discount notation. That means the net amount within 30 days or the amount of days that you decide. To give you a clear view, here’s an example of accounts payable and accounts receivable from CFI.
So, there you have it! Accounts payable and accounts receivable are two different ends of the spectrum. However, it’s still essential for you to distinguish one from the other. Hopefully, this guide will show you just that. Use this article as a reference whenever you feel like you need to review your knowledge about these two terms. If you need a billing software that will take care of your accounts receivable, feel free to contact us.