Accounts Receivable, Payable and Accrual Accounting – Accounting 101 #5
Accounting is simple when you're dealing with simple cash transactions. But what happens when you give or get credit?
- Accounts Receivable
- Accounts Payable
You use Accounts Receivable to track unpaid customer invoices and Accounts Payable to track unpaid vendor bills.
Accounts Receivable Example
Here’s an example of using Accounts Receivable.
Akko catered a party, charging $2,000. At the party, she gave the customer an invoice that had to be paid in 30 days. How do we record this?
Recording this entry into the Accounting Equation Cheat Sheet would start off like this. We want to increase revenues by $2,000, so we credit revenue, specifically the catering sales account. So we choose catering sales, enter ID 1, and $2,000. That's the simple part.
Because we increased our equity (increasing revenue, increases net income, which increases equity), we want to increase our assets as well to balance out the equation. But we didn't get paid the $2,000 yet, so we can't debit our bank account by $2,000. That's where the accounts receivable account comes in. We use that account to represent the $2,000 that is owed from that catering gig. So, we debit accounts receivable, enter a matching ID of 1, and enter in $2,000. Now Assets = Liabilities + Equity and the accounting world is once again in harmony.
You may now be wondering, what happens when 30 days down the road the $2,000 is received. Breaking this down into accounting terms, what we want to do is increase the money in our bank account and decrease the money that is owed to us (i.e. decrease the amount of money in our accounts receivable account). To increase an asset, we debit it, so we choose bank account, enter an ID of 2, and enter in $2,000.
Likewise, to decrease an asset (our accounts receivable account), we credit it. So we choose accounts receivable, choose a matching ID of 2, and enter in $2,000.
What this entry does is simply move the money from one asset account to another asset account. Instead of the customer owing us $2,000, that money is now in our bank.
Nothing about the Accounting Equation has changed, we still have $2,000 in assets and $2,000 in equity.
And that's right, because we didn't make another sale to get the $2,000 in our bank account, we simply collected on the $2,000 owing to us. So, while we always need to make sure that Assets = Liabilities + Equity, we don't always need to do this by increasing both sides of the equation. In this case, we increased and decreased Assets by the same amount, $2,000.
Accounts Payable Example
The process used for accounts receivable is also the same one used for accounts payable.
Accounts payable is used in a situation where Akko purchases an ad for $1,000, and instead of paying for it right away, receives a bill giving her 30 days to pay.
To record this entry in the Accounting Equation Cheat Sheet, we first enter the expense. We want to increase our expenses, so we debit it. We choose the advertising expense account, give it an ID of 3, and enter in $1,000.
Now we enter the other side of the entry. Remember, we didn't use our bank account to pay, instead we received a bill from Adoogle saying that we have to pay later. This is a liability, money that we owe. If we want to increase the money we owe, we credit the liability. So we
choose the accounts payable account, enter the matching entry ID of 3, and put in $1,000.
What this entry is saying is that we increased our expenses by $1,000 and we also increased our liabilities, the money we owe, by $1,000 as well.
Now when we go to pay the bill using money in our bank account, this is what we'll need to do. We need to decrease the money in our bank account as well as decrease the amount of money we owe. We can record any part of the entry first, but let's start with decreasing the amount of money we owe. If we want to decrease the liability account, we debit it. We choose the accounts payable account, give it an ID of 4, and enter in $1,000.
Now we need to decrease our bank account (our asset), so we credit it. We choose bank account, a matching ID of 4, and enter in $1,000.
What has happened is that our liabilities are back down to $0. We owed $1,000 for the advertising bill, and paid it off with our bank account, so now we owe nothing. Since we used our bank account to pay for the bill, our bank account also decreased by $1,000. We used to have $2,000 in the bank, now we have $1,000.
What these two examples have demonstrated to you is accrual accounting. What in the world is accrual accounting?
In accrual accounting sales are considered revenue at the time they're earned – in other words the time that a sale was made – and not when the actual cash was collected. Likewise, purchases are considered expenses at the time the purchase was made, not when it's actually paid for. And accounts receivable and accounts payable are used to do this.
To better understand accrual accounting, you need to understand its counterpart, cash accounting. Unlike accrual accounting, sales are considered revenue at the time you receive money and purchases are considered expenses when you actually pay for them. In cash accounting, we don't use accounts receivable and payable accounts. For that catering sale, the sale is only entered when the invoice is paid, so we only record one entry crediting the catering sales account and debiting the bank account.
Similarly for the advertising expense, we only record an entry once the bill is paid, debiting the expense account and crediting the bank account.
Cash accounting sounds simpler, doesn't it? Only one entry to enter instead of two. However, with simplicity we lose detail. In cash accounting if we have $5,000 in outstanding invoices owing to us and $10,000 in outstanding bills that we owe, we would never realize we owe $5,000 more than we have because we don't record these transactions in our accounting records.
Because accrual accounting allows for a more detailed look at a business's financial picture, it is the standard accounting practice of the majority of businesses all around the world. For some small businesses, cash accounting is used, but as a business gets bigger, it's inevitable that the business will need to start using accrual accounting instead.
Here's a recap of the key words and concepts we just learned.
- Accrual Accounting
- Cash Accounting
- Accounts Receivable
- Accounts Payable
In our next lesson, we'll talk about how to figure out how much money your business has made and how much it's worth. In other words, we're going to talk about the Profit & Loss and Balance Sheet reports.
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