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Accounts Payable: What Is It And How It Works

Accounts Payable Defined and Explained
Mike Zaccardi
Mike ZaccardiUpdated July 26, 2022
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Accounts payable are the bills and other short-term debts that a business needs to pay. It includes all of a company's current liabilities (due within one year), making it a key component of small business accounting. Understanding accounts payable and having a dependable accounts payable system is essential to running a successful small business. Here’s what you need to know.

Accounts Payable Definition 

When a business buys goods or services from a vendor or supplier on credit that needs to be paid back in the near term, the accounting entry is known as “accounts payable.” On a balance sheet, accounts payable appears under current liabilities. Accounts payable differs from a loan payable in that accounts payable do not charge interest (unless payment is late) and are typically based on goods or services acquired. Loan payables, such as balances on various kinds of business loans, generally charge interest and are based on the prior receipt of a sum of cash from a lenderIn a company, the term “accounts payable” is also used as the name of the department responsible for handling vendor invoices and bills, from recording them in the general ledger to making payments to suppliers and other third parties.

Is Accounts Payable an Asset or Liability? 

In small business accounting, accounts payable is a liability since it is money owed to vendors and creditors. The account grows larger when more money is owed to vendors. When accounts payable increases, a business will typically have more cash on hand because of the delay in paying amounts owed. This typically results in a temporary increase in liquidity.The short-term debt in accounts payable can help keep cash on hand to pay for other items, but eventually creditors will require payment. Accounts payable differs from business expenses. Accounts payable is shown on a business’s balance sheet, whereas business expenses are shown on the income statement.

How Accounts Payable Works 

When a business purchases goods or services from a supplier on credit, also known as trade credit, payment isn’t made immediately. Typically, it will be due within 30 or 60 days, or sometimes longer. How it works: A business will send the supplier a purchase order. The supplier will then provide the goods or services the business purchased, along with an invoice requesting payment by a certain date. The person or department responsible for accounts payable will verify the invoice against the purchase order and ensure the goods or services were received before issuing payment to their vendors. If amounts owed to suppliers and other third parties are not paid within the agreed terms, late payments or defaults can result.The sum of all outstanding payments owed by a business to third parties is recorded as the balance of accounts payable on the company’s balance sheet. Any increase or decrease in accounts payable from one accounting period to another will appear on the cash flow statement.Recommended: 6 Business Cash Management Tips 

4 Steps of the Accounts Payable Process

Managing business finances is one of the most important aspects of running a small business. The accounts payable process has four key steps. Going through this defined process helps avoid errors and missing a payment deadline to a vendor.  

1. Invoice Capture 

The accounts payable process generally begins when a supplier or third party submits an invoice to the accounts payable department. After receiving the invoice, the accounts payable clerk will verify the invoice is valid and not a duplicate, code the invoice to the general ledger, and depending on the company's process, conduct a two-way match (in which invoices are matched to purchase orders) or a three-way match (in which invoices are matched to purchase orders and receiving information).

2. Invoice Approval 

Once all the data is entered, an invoice must be approved. This involves an individual from the accounts payable department routing the invoice to the appropriate person (or people) in the company to get the necessary approval(s).

3. Payment Authorization 

After an invoice is approved, the accounts payable clerk may need to get authorization to make a payment. The authorization will typically include the payment amount, method of payment, and date the payment will be made.

4. Payment Execution 

Once payment is authorized, the invoice can be paid. Payment should be processed before or on the bill’s due date and may be done by check, electronic bank-to-bank  payment, or credit card. Once the invoice is paid, it can be closed out in the accounting system.

Internal Controls and Audits 

Internal controls are standardized operating procedures used by companies in their accounts payable process to reduce the risk that a business will pay a fraudulent or inaccurate invoice, pay a vendor invoice twice, and/or fail to pay an invoice on time. These controls often include:
  • Purchase order approval
  • Invoice approval 
  • Two-way matching (in which invoices are matched to purchase orders) or three-way matching (in which invoices are matched to purchase orders and receiving information)
  • Auditing for duplicates (which involves checking files manually or with an accounts payable automation platform to make sure duplicate payments aren’t made)

Accounts Payable Examples 

Generally, any items bought on short-term credit fall under the accounts payable umbrella. This includes:
  • Licensing costs
  • Leasing costs
  • Subcontractor bills
  • Amounts owed for raw materials and fuel
  • Products and equipment received but not paid for
  • Subscription services
  • Installment payment plans
Recommended: Credit Memo vs. Debit Memo Explained

Accounts Payable vs Accounts Receivable 

Accounts receivable is basically the opposite of accounts payable. While accounts payable is the money a company owes to suppliers and vendors, accounts receivable is the money that is owed to the company, generally by its customers. If two companies make a transaction on credit, one records it to account payable, while the other records it to accounts receivable.Here’s a side-by-side comparison of accounts payable vs accounts receivable:
Accounts PayableAccounts Receivable
Money you owe to a vendor or other third partyMoney owed to you from customers
Recorded as a current liability on the balance sheetRecorded as a current asset on the balance sheet
When a business owner needs an influx of cash, accounts receivable financing is a type of financing that enables them to receive early payment on outstanding invoices. The owner must then repay the money (plus a fee) to the financing company when they receive payment from their customers.

Trade Payables and Accounts Payables 

Though they sound similar, trade payables are actually slightly different from accounts payables. Trade payables are amounts a company owes its vendors for inventory-related goods, such as business supplies or materials that are part of the company’s inventory. Accounts payables, on the other hand, includes trade payables, as well as all other short-term debts.

The Takeaway

Accounts payable is a current liability on a company’s balance sheet. Accounts payable includes all of the short-term credits extended to a business by vendors and creditors for goods or services rendered but not yet paid for. Accounts payable also refers to the department or person in a firm that records and handles purchases and payments. Lenders and potential investors will often look at a company's accounts payable, as well as their accounts receivable, to gauge the financial health of a business. Mismanagement on either side of the equation can have a negative impact on your business’s ability to get credit or get approved for a small business loan, and could also put your business at risk.

3 Small Business Loan Tips

  1. Generally, it can be easier for entrepreneurs starting out to qualify for a loan from an online lender than from a traditional lender. Lantern by SoFi’s single application makes it easy to find and compare small business loan offers from multiple lenders.
  2. Traditionally, lenders like to see a business that’s at least two years old when considering a small business loan.
  3. SBA loans are guaranteed by the U.S. Small Business Administration and typically offer favorable terms. They can also have more complicated applications and requirements than non-SBA business loans.

Frequently Asked Questions

What are examples of accounts payables?
What is the purpose of accounts payable?
What is accounts payable reconciliation?
Photo credit: iStock/KamiPhotos

About the Author

Mike Zaccardi

Mike Zaccardi

Mike Zaccardi, CFA, CMT, is a finance expert and writer specializing in investments, markets, personal finance, and retirement planning. He enjoys putting a narrative to complex financial data and concepts; analyzing stock market sectors, ETFs, economic data, and broad market conditions; and producing snackable content for various audiences.
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