Accounts Payable and Accounts Receivable

A/R (Accounts Receivable) and A/P (Accounts Payable) are advanced concepts that are used by businesses to record sales for which they are not paid right away, or to record bills that they have received, but might not pay until a little while later.

These types of accounts are used primarily when you've got a lot of bills and receipts flowing in and out, and don't want to loose track of them just because you don't pay/get paid right away.

For almost all home users, A/R and A/P are too complicated and confusing to be worth the effort.

Accounts Receivable

First, let us examine A/R. After all, we really shouldn't really need to relate to A/P because we always pay our bills on time, don't we ? :-)

As a first approximation, let us assume we don't require customers to pay instantly, in cash, but rather issue them an invoice, and give them 30 days to pay the bills. (After 30 days, we can start charging interest and sending out harassing letters :-)).

When we make a sale, the two accounts affected are Sales (an income account) and Accounts Receivable. Accounts Receivable is an asset, but it's not "liquid," as you can't readily sell it, and it's certainly not cash.

Then when they come by to pay their bill, dropping off a large sack of twenty-dollar bills (or, more likely, a check/cheque), we transfer the amount from A/R to Cash.

The reason we do this in two steps is that we have decided we need to do our accounting on an accrual basis and not on a cash basis, because most of our transactions are not solely based on cash changing hands, but rather based on establishing obligations.

In more sophisticated operations, there may be a much more complex sequence of documents generated and tracked:

The fact of there being four documents leads to there being considerable wads of paper, and having these and other such processes explains why large organizations tend to have hefty bureaucracies.

We report sales in our sales figures as soon as we make them. Unfortunately, we may wind up selling some product to no-good shady operators that we didn't know were shady, and thus may get stuck with some "bad debts."

In order to determine which parts of Accounts Receivable appear to be most at risk, it is typical to arrange AR based on the "ages" of the debts, commonly segmenting it into several aging periods, of payments outstanding 0-30 days, those that outstanding 31-60 days, 61-90 days, and then those that are way overdue.

At some point, it may become clear that a customer is never going to pay what they owe, and we have to write it off as a Bad Debt.

At that point, it is typical to record an entry thus:

Account DR CR
Bad Debt Expense $10,000
Accounts Receivable $10,000

We could have reduced Sales Income instead, but companies tend to prefer to specifically track the amount that they're losing to bad customers.

Warning: Advanced Accounting Concept. Bad Debt is an example of a "contra-account." That doesn't refer to amounts paid to Nicaraguan rebels, but rather the notion that the account is an income account that is expected to hold a balance opposite to what is normally expected, to be counteract the balance in another income account. Accumulated Depreciation, used to diminish the value of an asset over time, is another example of a contra-account.

Accounts Payable

The scenario for Accounts Receivable, reversed, reflects how Accounts Payables work; just switch customer with supplier, and watch the roles reverse.

Prepaid Expenses

Analogous techniques are also used for expenses that are pre-paid.

If you have to pay out down six months of rent in advance, that is treated as an "accrued asset."

Similarly, companies collect payroll taxes on behalf of employees, and keep them in a special bank account.


Return to Main Documentation Page.