In commercial businesses, sales and purchases of goods and services are among the most frequent transactions. The larger the business, the higher the volume and value of such transactions. While small-value retail transactions typically take place on cash basis, wholesale purchase and sale transactions often take place on credit basis. Owing to the high volume and value, sellers often allow a predetermined credit period within which the buyers are required to settle payments for their purchases. In fact, the most such regular sellers and buyers have running accounts with each other that reflect the sales/purchases made and the payments received/paid against them. These running accounts reflect, at any time, the balances outstanding for receipt or payment.
Definitions and meanings
Accounts receivable is the balance of the buyer or customer in the books of the seller or supplier. It represents the amount that is owed to and due to be received by the seller from the buyer.
When a seller provides goods or services to the buyer, he generates an invoice for the same. On the basis of this invoice an accounts receivable is created in the books. If goods are returned or payments are made by the buyer, the balance of accounts receivable is reduced to that extent. There may also be circumstances in which the buyer is declared bankrupt and is unable to pay his dues. In such cases, the balance of accounts receivable is written off as bad debts in the books of the seller.
John & Peter Inc. is a wholesaler of sporting goods. It has several regular distributors, retailers and stockists, including Robert Brothers. On July 1, 2021, John & Peter Inc. sells goods worth $50,000 to Robert Brothers on terms 2/10 n/30 (ignore sales tax). This means a credit period of 30 days is extended and a cash discount of 2% is offered if payment is cleared within 10 days of purchase. Robert Brothers could not avail the discount offered by the seller for early payment but settled the full payment on July 25.
The journal entries to record the accounts receivable in the books of John & Peter Inc. are:
Journal entry to record accounts receivable on July 1, 2021:
Accounts receivable a/c…..50,000 [Dr]
Sales a/c…..50,000 [Cr]
Journal entry to record the collection of accounts receivable on July 25, 2021:
Cash a/c…..50,000 [Dr]
Accounts receivable a/c…..50,000 [Cr]
Although we have not incorporated the sales tax in above example, accounts receivable usually include not only the actual amount of sales transactions but also the amount of sales tax. Sellers are often responsible to follow specific governmental instructions in collecting sales tax from their buyers and remit the same to a dedicated tax authority.
Being a short-term receivable, accounts receivable qualifies as a current asset and is reported as such on the asset side of the balance sheet.
Accounts payable is the balance of the seller or supplier in the books of the buyer or customer. It represents the amount that is outstanding and due to be paid by the buyer to the seller, generally on account of a credit purchase transactions. It is essentially the flipside of the accounts receivable balance in the books of the seller.
In the same way as an accounts receivable is created, the buyer creates an account payable of the seller when he receives the sales invoice from him. The balance of accounts payable is adjusted either when the buyer returns the goods to the seller or settles a payment against a previous credit purchase.
Continuing the same example above, the journal entries to record the accounts payable in the books of Robert Brothers are:
Journal entry to record accounts payable on July 1, 2021:
Purchases a/c…..50,000 [Dr]
Accounts payable a/c…..50,000 [Cr]
Journal entry to record the payment made to accounts payable on July 25, 2021:
Accounts payable a/c…..50,000 [Dr]
Cash a/c…..50,000 [Cr]
Being a short-term payable, accounts payable qualifies as a current liability and is reported as such on the liability side of the balance sheet.
Difference between accounts receivable and accounts payable
The difference between accounts receivable and accounts payable have been detailed below:
- Accounts receivable is the balance that is due to a seller from his credit customer, reflected in the books of the seller.
- Accounts payable is the balance that is outstanding and to be paid by the customer to his seller or creditor, reflected in the books of the customer.
2. Reflected in the books of
- Accounts receivable appears in the books of the seller/supplier.
- Accounts payable appears in the books of the buyer/customer.
3. Arises due to
- Accounts receivable generally arises due to sale of goods or provision of services on credit by a seller.
- Accounts payable generally arises due to purchase of goods or availing of services on credit by a buyer.
4. Nature of balance
- Accounts receivable has a debit balance and qualifies as a current asset.
- Accounts payable has a credit balance and qualifies as a current liability.
5. Financial accounting and reporting
- The balance of accounts receivable is recorded under ‘current assets’ on the asset side of the balance sheet.
- The balance of accounts payable is recorded under ‘current liabilities’ on the liability side of the balance sheet.
6. Impact on working capital position
- Having the potential of cash inflow for the business, the balance of accounts receivable improves its working capital position.
- Having the potential of cash outflow for the business, the balance of accounts payable worsens its working capital position.
7. Accounting for potential non-payment
- In case circumstances arise that make all or part of the accounts receivable non-recoverable, the seller can make a provision for doubtful receivables which will be set off against the accounts receivable balance in the balance sheet. This practice is in accordance with the principle of prudence.
- On the other hand, there is no such provision that allows a provisional write back of accounts payable. Only actual write back can take place under specified circumstances.
For transactions between a particular seller and buyer, the balance of accounts receivable in seller’s books and the balance of accounts payable in buyer’s books represent two sides of the same transaction. They should thus reflect the same balance in the books of both the specific seller and buyer. In practice, however, there may be several discrepancies between these two balances. Some of the causes for such discrepancies can be goods in transit, mismatch in physical tally of goods received or goods returned etc. It is for this reason, that sellers and buyers exchange periodic balance statements to identify discrepancies, if any, and reconcile the same.