Accounts payable

Definition and explanation

Accounts payable (also known as creditors) are balances of money owed to other individuals, firms or companies. These are short term obligations which come into existence when a sole proprietor, firm or company purchases goods or services on account. Accounts payable usually appear as the first item in the current liabilities section of a company’s balance sheet.

Accounts payable are usually divided into two categories – trade accounts payable and other accounts payable. Trade accounts payable are the obligations for the purchase of goods that are merchandise inventory whereas other accounts payable are the obligations for the purchase of services and goods that are not merchandise. Merchandise are the commodities that a company normally deals in. The goods that are not merchandise are the goods that the company does not normally deals in.

Mostly, the companies find it convenient to record accounts payable liability when the goods are actually received by them. However, in certain situations where the title to goods passes before the actual receipt of goods, the liability should be recorded at the time of passage of title.

Journal entries related to accounts payable

Every time the goods or services are purchased on account, an accounts payable liability is created and recorded. The measurement of the amount of accounts payable liability is not difficult because the seller’s invoice usually contains the detailed information about the due date and the exact amount payable by the buyer.

The transactions relating to accounts payable are repetitive in nature and many companies use a special journal known as purchases journal for recording these transactions. However, in small companies where the transaction volume is small, special journals are not maintained and these transactions are recorded in general journal along with other transactions.

The typical journal entries related to accounts payable are given below:

1. When merchandise inventory is purchased on account:

If merchandise inventory is purchased on account, the accounts payable liability is recorded by making the following journal entry

Purchases account [Dr.]
Accounts payable [Cr.]

The above journal entry to record accounts payable liability is made under periodic inventory system. If the company is employing a perpetual inventory system, the debit part of the entry would consist of “inventory account” rather than “purchases account”.

2. When damaged or otherwise undesirable inventory is returned to the supplier:

If a part or whole of the inventory purchased is found to be damaged or otherwise undesirable, the buyer may either return such goods to the seller or keep them and ask the seller for an allowance (i.e., a reduction in price). If such returns and/or allowance is approved by the seller, the buyer records a reduction in accounts payable liability in his accounting record.

The following journal entry is made to record the reduction in accounts payable liability resulting from approved returns and/or allowances:

Accounts payable [Dr.]
Purchases returns and allowances [Cr.]

If the buyer maintains a purchases returns and allowances journal, the goods returned by him would be recorded in that special journal rather than in the general journal or journal proper.

After making above journal entry in his books, the buyer informs the seller that his account has been debited by sending him a debit note (also named as debit memo).

3. When an asset other than merchandise inventory is purchased on account:

If an asset other than inventory such as plant, equipment, tools, furniture or some other fixed asset is purchased on account, the accounts payable liability is recorded as follows:

Relevant asset’s account [Dr.]
Accounts payable account [Cr.]

4. When expenses are incurred or services are purchased on account:

If some professional services (such as marketing, legal or IT related services etc.) are acquired or expenses are incurred and the payment for them is to be made in future, the accounts payable liability arises which is recorded by means of the following journal entry:

Relevant expense [Dr.]
Accounts payable account [Cr.]

5. When the payment is made to a creditor or payable:

When the payment is made to payable or creditor, the accounts payable liability reduces which is recorded by making the following journal entry:

Accounts payable [Dr.]
Cash [Cr.]

Example

The Chicago Corporation engaged in the following transactions during the month of January.

• Jan 01: Purchased $80,000 of inventory, terms 2/10, n/30, FOB shipping point. Paid freight costs of $600.
• Jan. 02: Returned damaged goods to supplier and received a credit of $12,000.
• Jan. 09: Paid cash to supplier for inventory purchased on January 1.

Required: Prepare all necessary journal entries assuming the Chicago uses a periodic inventory system and gross method of accounting for purchases discounts.

Solution: