As one of the biggest sources of liabilities on the balance sheet, accounts payable accruals can spur your company’s growth—or hobble it. Accurately tracking and maintaining your accounts payable balance prevents cash underruns, unwanted fees, and friction in your procurement process, all of which destroy progress.
Finance's accounting method may also impact the accuracy and stability of your financial reporting. For example, since it's straightforward, many small businesses and startups run financials using the cash basis of accounting. But as a business becomes more complex, a more accurate and compliant accrual method of accounting is preferred.
In this article, we’ll discuss the accrual method of accounting and the importance of accounts payable accruals in maintaining stable and accurate financials for your business. By the end of this article, you’ll understand:
- Cash versus accrual basis of accounting
- The importance of accruals to your accounts payable reporting
- Tips on managing accounts payable accruals
- How procurement software helps maintain accurate AP accruals
First, let’s clarify the difference between cash and accrual basis of accounting.
Accounting methods and terms explained
In its simplest form, accounting is the process of recording the money a company makes and spends.
- Money made (from any source) is called revenue. Revenue is the gross income a business makes before it subtracts expenses.
- Money spent (for any purpose) is called an expense. A company generates expenses for overhead (general business costs), wages, materials, and production.
There are two methods an accountant or CPA uses to record the money coming into and out of a business. These are called the cash basis of accounting and the accrual basis of accounting.
The cash basis of accounting works as follows:
- When you receive money, you record it as revenue.
- When you spend money, you record it as an expense.
While this is a simple way of looking at financials, the cash basis isn't accurate enough for businesses with more complex financial activity. Cash basis accounting does not meet the standard for Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).
These businesses use the accrual basis of accounting:
- Income is recognized when earned. This may or may not be when you are paid. For instance, you might receive payment via a yearly contract with quarterly retainer payments.
- Expenses are recognized when they are incurred. This may or may not be when you pay the invoice. For instance, you may order inventory on credit to be delivered later.
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Why should you use the accrual basis of accounting?
The reality of business transactions is that bills aren’t always paid as soon as services are rendered or products are delivered. But a large bill to be paid later still affects your company’s financial picture.
Cash basis accounting records a change only when the bill is paid. With accrual accounting, revenue and expenses are recorded when they occur—rather than when payment is made.
Even if a short-term liability isn’t due to be paid for 60, 90, or 180 days, it still appears on your balance sheet as a liability, so you know it’s on the horizon.
This gives you a clearer picture of your accounting. But it also makes things a little more confusing and requires extra bookkeeping.
In accruals basis accounting, you must reconcile credit and debit information for accounts receivable (revenue) and accounts payable (expenses) at the end of the accounting period.
Adjust the balance sheet when payment is made to ensure it matches what was previously recorded by creating a journal entry to adjust the general ledger (GL). These adjustments are called accruals.
Tips on managing accounts payable accruals
To understand accounts payable accruals further, let’s focus on expenses recorded under the accrual method.
Some of these are consistent, ongoing expenses. The cost of utilities and upcoming employee wages are examples of these expenses.
Goods or services provided by a third-party supplier may also be consistent and ongoing, but these are accounts payable accruals. Accounts payable refers specifically to short-term debts (those repayable within 12 months) owed to vendors. This differs from notes payable, which refers to long-term debts whose payment occurs over a longer period.
Like accrued liabilities such as loan payments and wages, accounts payable count as current liabilities. But often, these payments are harder to track and reconcile than recurring, predictable expenses like payroll or loan payments. Developing an effective strategy for these is essential to avoid running afoul of financial regulations.
Let’s look at how a business can take steps to improve the accuracy of its accounting.
- Verify the accrual invoice, vendor, and goods
Accuracy and timely delivery of orders are essential to maintaining strong financial performance. When ordering supplies, services, or products, it’s important for purchasing and AP departments to verify and reconcile the goods delivered against the goods ordered.
This process is called three-way matching. It verifies that the purchase order, invoice, and receipt of goods (sometimes called a bill of lading) all match—including price, terms, item quantity, and item quality.
- Increase scrutiny on large orders and unknown vendors
When working with or processing invoices from a new or unknown vendor, take time to verify that the invoice is tied to an actual order that has been received, accepted, and reconciled. Not only does this increase the accuracy of your financial statements, but it also detects and prevents procurement fraud.
Another way to prevent fraudulent activity is to segregate reconciliation duties in your organization. Different employees should review accrued expenses, adjust entries, reconcile orders, and verify vendor information. An accounts payable audit program improves accuracy and dissuades bad actors from perpetrating fraud.
- Make review part of month-end close activities
Month-end closing is vital to the financial health of your organization. A robust month-end close process covers all the bases with your vendors and short-term liabilities. Reviewing your cash accounts and accurately reconciling AP and AR accruals is key to a smooth month-end close. This practice ensures the numbers accurately reflect your current financial position.
- A robust month-end close process reduces the time-to-close, saving money and allowing AP teams to focus on other high-priority activities.
- Accurate month-end closing figures translate to strong and accurate financial statements.
- Accurate financial statements empower business growth through stabilized cash flow, access to loans, and attractiveness to potential investors.
How Order manages AP accruals
The accuracy of your company’s income statement, balance sheet, and cash flow statement relies on accurately keeping track of your short-term liabilities. If you don’t properly track and reconcile expenses, your end-of-the-year financial outlook will not accurately reflect how your business performed.
Procurement software automates that workflow and removes human error. Using Order to automate and streamline purchasing:
- Enables automatic approval, purchase order, and three-way matching workflows to ensure accuracy of purchases and payments
- Reduces human error and procurement fraud that damage financial performance
- Creates an accurate record of your purchase history, spend management, and procurement reporting for future analysis
- Centralizes data used for reconciliation and financial reporting at month end
Would you like to learn more about using procurement software to make managing accounts payable accruals easier? Schedule a demo of Order today.