FINANCIAL REPORTING

A Closer Look at Accounts Receivable and Accounts Payable

The accounts receivable (AR) and accounts payable (AP) lines on the balance sheet are important components of working capital, which we defined as the difference between current assets and current liabilities in The Balance Sheet – Part 1. The receivable and payable balances represent the aggregate total of the individual receivables and payables on your books as of the balance sheet date.

AR and AP share two important characteristics:

  • They involve “accrual” of revenue with a corresponding increase to Accounts Receivable (AR) or accrual of expense with a corresponding increase to Accounts Payable (AP). Accrual means that an event is recorded as a revenue or expense before cash is received or paid. Accrual is a basic feature of Generally Accepted Accounting Principles (GAAP). Two examples:
    • Receivable—Summer camp tuition is accrued when the student has registered and an invoice is sent to the parents
    • Payable—Office supply expense is accrued when the items are delivered and an invoice is received.
      • They age with time. Management, board, and auditors are interested in how long the receivables and payables have been sitting on the books. The “aging report” breaks them down into thirty, sixty, and over-ninety-day columns. When the majority of receivables and payables are less than thirty days old, all is right with the world. A large number of receivables or payables older than ninety days is evidence that, at best, operations need to be improved, and at worst, the organization is experiencing a serious cash problem.

      I once read about an organization whose parent company administered the health insurance for the employees of its affiliates and billed the affiliates each month. Experiencing cash flow problems, an affiliate stopped paying the health insurance bills and the payable balance grew. When the parent attempted to collect payment after more than a year, the amount owed had mushroomed. While boards do not usually review aging reports, I recommend noting on the balance sheet the aggregate amount of receivables and payables over ninety days old. This would have clearly signaled to the affiliate’s board that the organization had a problem.

      ACCOUNTS RECEIVABLE – THE BASICS

      A receivable indicates an expected inflow of a specific amount of money from a third party during a predictable time period. The receivable is either a third party’s promise to give or a third party’s obligation to fulfill the conditions of an agreement.

      Promises to give by a third party:

      • A donor pledge for a specific amount over a specific time period is received.
      • Written notification of a bequest of a specific amount from the estate of a deceased person is received.

      Obligations of a third party to fulfill the conditions of an agreement:

      • You have performed a service and billed the third party.
      • An “unconditional grant” is officially awarded. Click here for an explanation of this term.
      • A business owner agrees in writing to sponsor a fundraising event for a specific amount.

      Activities that are NOT a promise to give or an obligation of a third party:

      • A fundraising appeal letter is mailed out.
      • A grant application is submitted.
      • A hundred tickets for a fundraising dinner are given out to board members to sell.
      • You are notified by the executor of a deceased person’s estate that the will bequeaths a percentage of the estate to the organization.

      In all of these cases there is not enough certainty either that a future payment will be made or what the amount will be.

      Recording of a receivable affects both the income statement and the balance sheet. A $25,000 donor pledge, even if it is a multi-year pledge, will trigger an addition to accounts receivable (debit) with an offsetting increase to revenue (credit). As payment is made there is no entry to revenue; cash is increased (debit) and accounts receivable is reduced (credit).

      When we record a receivable we are making an assumption that the cash will eventually materialize, but there are many opportunities for receivable balances to be inaccurate through faulty assumptions, errors, or fraud. When it comes time to prepare the annual financial statements, the auditors will want to satisfy themselves that your receivables are well documented, reported in the correct year, and collectible.

      ACCOUNTS PAYABLE

      A payable indicates an obligation of the organization to pay a specific amount of cash during a specific time frame.

      Events that trigger a payable to be recorded in the general ledger:

      • An invoice is received for products that have been delivered.
      • Employee hours are worked.
      • 401k employer contributions are due in accordance with the plan document.

      Events that do not trigger a payable to be recorded in the general ledger:

      • You sign a lease agreement before taking occupancy of the rental space.
      • A purchase order for office supplies is sent to a vendor.
      • A proposal from a contractor for a renovation project is received.

      Accounts payable is more straightforward than accounts receivable because you decide when you will pay your bills, whereas receivable balances are based on assumptions about what external parties such as donors, government entities, and customers will do. There is no area of payables that is comparable to the accrual of grant receivables, which involve wading into the morass of the GAAP revenue recognition standards.

      Most of the time receipt of an invoice from a vendor will trigger an increase to accounts payable (credit) with an offsetting increase to expense (debit) by the amount of the invoice. As you near the end of the year, the timing of increases to accounts payable becomes critical because they affect net income. Managers who are anxious to use up grant money before the end of the year need to be reminded frequently that issuing a purchase order on 12/31 will not do the trick, because the items must be delivered before the entry can be made to accounts payable and expense. The mad dash to order computers at the end of the year must occur in November, not December, to allow time for delivery. Similarly, signing a contract with a consultant on 12/31 for $20,000 to prepay a year of training will not result in a payable and expense. Even if a check is written, you still have not used up your grant money, because the $20,000 will be classified as a “prepaid asset” on the balance sheet, not as a payable with a corresponding expense.

      Like receivables, payables present opportunities for errors and fraud. The auditors will look at a sample of your payable transactions before and after the end of the year. They will ask for invoices and shipping documents to ascertain that they were recorded in the correct year. They will also look at your aging report and ask questions about payables in the sixty, ninety, and over ninety-day groups.

      TO CONCLUDE

      The majority of the transactions that your business office processes every day boil down to net income on the income statement with offsets to AR and AP on the balance sheet. General ledger architecture, staff training, and regular, thorough review of journal entries, data entry, and aging reports will result in accurate financial information that executive management and the board can trust.