Five Minutes For Finance - Accounts Payable
Understanding Accounts Payable
The previous article in this series continued the discussion of nonprofit financial reports. All of these reports, it was noted, are based on the accrual basis of accounting. In this type of accounting, expenses are recognized when they are incurred, not when they are paid. This practice gives rise to the concept of Accounts Payable.
What are Accounts Payable?
Accounts Payable (AP) refers to the money an organization owes to external vendors, suppliers, or service providers for goods or services received but not yet paid for. These obligations are recorded as liabilities on the company's balance sheet. Accounts Payable is typically considered a short-term liability because payments are usually due within a short period, such as 30, 60, or 90 days.
The AP process involves tracking incoming invoices, verifying their accuracy, and processing payments. Managing AP efficiently is crucial for maintaining good cash flow and avoiding late fees or strained vendor relationships.
Key Functions of Accounts Payable
Invoice Processing: The accounts payable team receives invoices from vendors for goods or services rendered. These invoices must be reviewed for accuracy, ensuring that the goods or services billed match the original purchase order or contract terms. This process is known as three-way matching (comparing the invoice, purchase order, and receiving report).
Payment Approval: Once invoices are verified, they typically require approval from the relevant department or manager before being paid. This step helps ensure that only legitimate expenses are processed and helps prevent fraud.
Payment Scheduling: After approval, payments must be scheduled based on the payment terms agreed upon with the supplier. This can include early payment discounts, net terms (e.g., net 30, net 60), or specific due dates.
Cash Flow Management: Effective management of accounts payable helps ensure the organization maintains adequate liquidity to meet its financial obligations. By scheduling payments strategically, organizations can optimize their cash flow and avoid running into financial trouble.
Record Keeping: AP involves thorough documentation of all transactions. Proper record-keeping ensures that the company has accurate financial data for reporting, tax purposes, and auditing. This includes storing invoices, receipts, and payment records.
Best Practices for Managing Accounts Payable
Streamline Processes with Automation: In today’s digital age, many organizations are moving towards automating their AP processes. Tools like accounting software or third-party bill payment systems can automatically capture, match, and process invoices, significantly reducing human error and increasing efficiency. Automation also helps with early payment discounts by ensuring timely payments and reducing administrative burden.
Implement Strong Internal Controls: Preventing fraud and errors in the AP process is vital for protecting the organization. Segregating duties (e.g., separating invoice approval from payment processing) and regularly auditing AP transactions are key internal controls to reduce the risk of mistakes or intentional misappropriation of funds.
Negotiate Favorable Terms with Vendors: Building strong relationships with vendors can lead to favorable payment terms, such as extended due dates or discounts for early payment. Negotiating good terms not only helps with cash flow management but also builds trust and reliability between your organization and its suppliers.
Monitor Cash Flow Closely: Proactively manage your cash flow by regularly reviewing upcoming AP obligations and ensuring that sufficient funds are available to cover them. Consider using cash flow forecasting tools to predict future obligations and avoid unexpected shortages.
Prioritize Payments Strategically: Not all payments are equally urgent. Use a priority system to manage AP based on factors such as due dates, vendor relationships, and the availability of early payment discounts. For example, it may be worth prioritizing a payment with a 2% discount for early payment, as it provides a financial incentive.
Regular Reconciliation: To ensure accuracy in financial reporting, reconcile the AP ledger with vendor statements regularly. Discrepancies should be addressed promptly to maintain trust with suppliers and avoid payment delays or disputes.
The Impact of Effective Accounts Payable Management
Improved Cash Flow: Efficient AP management helps to optimize cash flow. By paying bills on time, organizations can avoid late fees and interest charges, ensuring that their cash flow remains steady and predictable. Similarly, maintaining healthy vendor relationships can sometimes result in more favorable terms or discounts.
Stronger Vendor Relationships: Consistent, timely payments build trust with suppliers and vendors. In turn, vendors may be more willing to provide better terms, improve service, or offer discounts to organizations that maintain a solid reputation for paying on time.
Accurate Financial Reporting: AP management contributes to accurate financial reporting, which is essential for making informed business decisions. Whether preparing for audits, forecasting future expenses, or reporting to funders, organizations rely on up-to-date AP records to present an accurate picture of their financial health.
Better Credit Rating: Organizations that pay their invoices on time are more likely to maintain a strong credit rating. A good credit rating is essential for securing financing, negotiating better loan terms, and preserving financial credibility. Because nonprofit organizations face unique challenges in securing financing, positive vendor references can facilitate loan negotiations.
Common Challenges in Accounts Payable
Invoice Discrepancies: Disputes over pricing, quantities, or terms can delay the AP process. A systematic approach to matching purchase orders, invoices, and receipts can help resolve discrepancies faster.
Manual Data Entry Errors: If done manually, data entry can be prone to mistakes, such as inputting incorrect amounts, dates, or vendor details. Automation tools can help reduce these risks by capturing data directly from invoices and reducing human error.
Late Payments: Missed deadlines can lead to penalties, strained relationships with vendors, and damage to the organization’s reputation. The use of payment scheduling tools or reminders can mitigate the risk of late payments.
Fraud Risk: Accounts payable is a key area vulnerable to fraudulent activities, such as fake invoices or employee misappropriation of funds. Implementing robust internal controls and regularly auditing AP processes can help reduce this risk.
Conclusion
Accounts payable is a fundamental aspect of any organization’s financial management, helping ensure that financial obligations are met promptly and accurately. By adopting best practices—such as automating processes, maintaining internal controls, and monitoring cash flow—organizations can optimize their AP function, build stronger vendor relationships, and maintain healthy financial standing.
A well-managed accounts payable process not only improves operational efficiency but also contributes to overall financial success, enabling organizations to stay competitive, maintain liquidity, and foster positive relationships with suppliers and partners.
About this Series
Subsequent articles in this series will cover the various aspects of internal controls as well as other topics related to nonprofit financial management. Here is a list of, with links to, previous articles:
About the Author
For over 30 years, Robert Pascual has been a leader in nonprofit financial management as a CFO, consultant, conference speaker and educator. He holds an MBA from the Haas School of Business at the University of California and is the founder and principal of Robert Pascual, MBA LLC. He has worked with small, mid-size, and large nonprofit organizations spanning the fields of education, workforce development, housing, health, philanthropy, social services, media, fiscal sponsorship, nature, and the environment. Each of these organizations has faced both unique and common challenges, some of which are probably similar to ones that you wrestle with.