Focusing on the Flow of Money Into and Out of a Business

Accounts Payable (AP) and Accounts Receivable (AR) are fundamental components of financial management, focusing on the flow of money into and out of a business.

Accounts Payable (AP)

Definition: Accounts Payable refers to the money a business owes to its suppliers for goods or services received but not yet paid for.​

Key Functions:

• Invoice Processing: Reviewing and approving invoices from vendors.​

• Vendor Management: Maintaining records of suppliers and ensuring timely payments.​

• Payment Methods: Utilizing various payment methods such as electronic transfers, checks, or wire transfers.​

• Compliance: Ensuring adherence to internal controls and financial policies.

IRS Perspective: While the IRS doesn't provide a specific definition for AP, it is integral to tax reporting and financial compliance. For instance, the IRS requires accurate reporting of expenses related to AP to ensure proper tax deductions and compliance with tax laws.​

Accounting Treatment: AP is typically recorded as a liability on the balance sheet. Under the accrual basis of accounting, expenses are recognized when incurred, not when paid. This means that even if payment hasn't been made, the expense is recorded, affecting both the income statement and the balance sheet.

Best Practices for Managing AP

1. Maintain Accurate Records

   • Keep detailed records of all vendor contracts, payment terms, and invoices.

   • Ensure invoices match purchase orders and receiving documents (3-way match).

2. Automate When Possible

   • Use accounting software or ERP systems to track due dates and avoid late payments.

   • Tools like SAP, QuickBooks, Oracle, or NetSuite streamline approval workflows.

3. Leverage Payment Terms

   • Take advantage of early payment discounts (e.g., 2/10 net 30) when beneficial.

   • Avoid paying too early if it impacts cash flow.

4. Monitor for Fraud

   • Segregate duties (e.g., who approves invoices vs. who processes payments).

   • Watch for duplicate or suspicious invoices.

Example of Accounts Payable:

You as a business owner, owe a vendor for inventory that you have in your warehouse. You are making payments for the inventory to your vendor because you couldn’t pay for the full amount upfront. It is money you owe to someone else.

Accounts Receivable (AR)

Definition: Accounts Receivable represents the money owed to a business by its customers for goods or services provided on credit.​

Key Functions:

• Billing: Issuing invoices to customers for products or services delivered.​

• Collections: Monitoring outstanding invoices and following up on overdue payments.​

• Customer Relations: Maintaining positive relationships with clients while managing receivables.​

• Reporting: Generating reports to track receivables and assess financial health.​

IRS Perspective: The IRS provides guidelines on the treatment of AR for tax purposes. For example, under the nonaccrual-experience method, businesses may exclude certain uncollectible amounts from gross income, affecting the timing of income recognition and tax liabilities.

Accounting Treatment: AR is recorded as an asset on the balance sheet. Under the accrual basis of accounting, revenue is recognized when earned, not when received. This means that even if payment hasn't been received, the revenue is recorded, impacting both the income statement and the balance sheet.​

Best Practices for Managing AR

1. Credit Management

   • Establish clear credit policies and perform credit checks on new clients.

   • Set realistic credit limits and monitor customers' payment history.

2. Invoice Promptly & Clearly

   • Send invoices as soon as services are rendered or products are delivered.

   • Clearly list due dates, payment methods, and late fees.

3. Follow Up Strategically

   • Implement a systematic process for collections (emails, calls, formal notices).

   • Consider offering small incentives for early payment or automated billing options.

4. Track Aging Receivables

   • Use an Aging Report to monitor how long invoices have been outstanding.

   • Prioritize collections on older or higher-risk accounts.

Example of Accounts Receivable:

You as a business owner, have clients that owe you money. For example, you are a manufacturing company and you make products for your clients. Your clients can’t pay for their large orders all at once. They make payments to you over time. The money owed to you is Accounts Receivable.

Interplay Between AP and AR

AP and AR are interconnected components of a company's working capital management. Efficient management of both is crucial for maintaining liquidity and ensuring smooth business operations.​

How They Impact Financial Health

• Cash Flow: Efficient AP & AR management ensures liquidity — the lifeblood of any business.

• Working Capital: AR is a current asset; AP is a current liability. Together, they define working capital.

• Ratios to Watch:

  • DSO (Days Sales Outstanding) for AR: Lower is better.

  • DPO (Days Payable Outstanding) for AP: Higher is better (but not too high).

  • Current Ratio and Quick Ratio: Measure a company’s short-term financial health.

    
    

Pro Tip from Harvard Business School

Harvard often emphasizes that financial literacy around AP and AR is crucial not just for finance teams, but for leaders and managers across departments. Understanding these concepts helps you make better strategic decisions, whether you're negotiating supplier contracts or optimizing sales terms.

Example: A company that effectively manages its AP by negotiating favorable payment terms with suppliers can maintain better cash flow. Simultaneously, by managing AR effectively, such as by implementing efficient billing and collection processes, the company can ensure timely