More on purchases and payables

1 Introduction

This chapter looks in a little more detail at purchase transactions and the payables ledger.

The accounting documents used are:

1. When purchases are made, invoices will be received from suppliers
   

2. Statements will be received regularly from suppliers, setting out what is still owed and what has been paid.
   

3. When payments are made remittance advices should be sent to suppliers to explain which invoices are being settled.
   

2 Credit control

Suppliers should exercise credit control on their customers. The process starts with a new customer applying for credit and this should initiate some investigation, such as:

• The supplier will ask for the applicant's recent financial statements.
  

• The supplier will make enquiries to a credit reference agency to see if the applicant has any history of poor payments in the past.
  

Based on these investigations the application will be accepted or rejected, and the supplier will set a credit limit. It is important to watch that limit when more goods are ordered, because an order that would take the account over the limit is likely to be held up and delivery delayed.

To encourage payment, suppliers often:

• Send statements. These often act as a gentle reminder about what’s due.
  

• Offer settlement discounts. For example, pay 5% less if paid within 30 days.

3 Settlement discounts

For example, an invoice is issued by RSQ Ltd for $900 on 5th June 2013 with terms offering a settlement discount of 5% is settled within 30 days. The invoice was paid on 25th June 2013. Therefore, because it was paid on time the amount due will be $900 x 95% = $855.

The discount of $45 is a reduction in the expense of the business buying the goods. The supplier has ‘let off’ the buyer $45 for prompt payment.

The entries in the RSQ’s account would be:

The settlement discount is credited to the Discounts Received account in the general ledger. This is an income account.

Occasionally there is a memorandum settlement discount column in the cash account so that, in the case above, $855 would be the amount of cash paid and $45 would be entered in the memorandum column. The sum of the memorandum discount column would be credited to the Discounts Received account.

It is important to realise that the payables total account should always reflect in total whatever happens in the individual accounts. So, if a supplier gives a settlement discount, this must also be debited to the total payables account.

For example, consider a company with just three suppliers:

You will see that, the control/total account balance agrees with the sum of the individual balances in the payables ledger ($1,850 = $650 + $800 + $400)

Each supplier offers a settlement discount of 4% if the amounts are paid within 30 days. PQR Ltd and RST Ltd are paid within this time limit; UVW is not and is paid only $120 of what is owed.

After the payments and the settlement discounts, those accounts are:

Note that the sum of the individual balances (now UVW Ltd only) still equals the balance on the total payables account.

Note that a settlement discount is entirely different to a bulk or trade discount. The bulk or trade discount is to all intents and purposes a straight reduction in the price and the only amounts ever invoiced or treated as a purchase are after the discount has been removed.

With a settlement discount, the purchases and the invoices are for the full amount (after trade discount) and the discount is contingent upon prompt payment.

4 Purchase returns and credit notes received

When goods are sent back to a supplier the buyer asks for a credit note (usually by sending a debit note first — see chapter 1). When the supplier's credit note arrives it is listed in the purchases returns day book, and the day book's totals are posted:

Debit Payables control account $240

Credit Purchases returns account $200

Credit Sales tax account $40

and the gross $240 is debited to that supplier's own account in the payables ledger:

The settlement discount is 5% of the $660 actually owed after the credit note: 660 x 5% = $33, so $627 is paid.

A purchase return does three things, and they are the mirror of a sales return: it reduces payables, it reduces purchases (through the purchases returns account), and it reverses the input sales tax that was reclaimed on the goods going back.

4.1 Contra entries

Where the same business is both a supplier and a customer, the two balances can be set off. Put the contra through by journal for the LOWER of the two balances:

Debit Payables control account

Credit Receivables control account

and make the same two entries in that business's individual account in each memorandum ledger. Nothing is paid and nothing is received; only the balances move.

5 Making payments to suppliers

Invoices should be paid when due otherwise:

• Valuable settlement discounts will be lost
  

• Suppliers might become reluctant to continue to give credit because they fear invoices will not be paid.
  

Payments due lists can be prepared from the Payables ledger. This is rather like the Aged Receivables Analysis. A senior official will then go through this list and mark which payments to make.

Payments can be made by internet transfer or by cheque, but before payments are made they have to be carefully authorised to prevent incorrect amounts being paid - or money being fraudulently taken from the company.

Often the person approving the payment will want to see the supplier’s invoice, the goods received note and a copy of the authorised purchase order. Together, these three documents provide a good standard of proof that the supplier should be paid.

All payments should be accompanied by a remittance advice that sets out what is being paid so that the supplier can keep track of the account.

For example, consider this supplier’s account in the books of Azed Ltd:

The supplier, ABC Ltd, is sent a cheque for $4,800, and this is accompanied by a remittance advice as follows:

Preparing one is straightforward, and FA1 asks you to be able to do it. A remittance advice must show: who it is from and who it is to; the date; the supplier's account number if there is one; a line for EACH invoice being paid, giving the invoice number, its date and the amount; a line for each credit note being deducted, shown as a negative; the settlement discount being taken, if any; and the total, which must equal the payment actually sent, with the cheque number or the transfer reference.

Two rules matter. Put the invoice numbers on it — a supplier who is sent a payment with no advice has to guess which invoices it clears, and the aged analysis on both sides goes wrong. And make the total agree to the penny with the payment: if a discount is being deducted, say so on the advice, or the supplier will treat the account as short paid and chase the difference.

6 Reconciling a supplier statement

A supplier sends a statement of account every month. It is the supplier's version of the same relationship your payables ledger records, and the two should agree. Comparing them is the purchases-side equivalent of the bank reconciliation, and it is worth doing BEFORE you pay: it is the last chance to find an invoice you have never received, an invoice charged twice, a credit note you are owed, or a payment that has gone missing.

The method is the same as the bank reconciliation:

• Tick every item that appears on both documents. Those cannot be causing the difference.
  

• List what is left on each side.
  

• Decide, item by item, which are timing differences (they will clear on their own) and which are errors (somebody has to correct them).
  

• Start from the statement balance and work back to your ledger balance, adjusting for each reconciling item.
  

Here is ABC Ltd's statement to Azed Ltd for April:

Azed's own account for ABC Ltd shows a balance of $3,270 at 30 April ($8,070 less the $4,800 paid). The difference is $5,500. Working through the unticked items:

Look at what each item is telling you. The payment and the unreceived invoice are TIMING differences and need nothing doing — the payment will appear on May's statement, and invoice 2291 will be posted when the goods and the invoice arrive. The credit note is different: ABC has issued credit note 318 for $400 but Azed has not yet posted it. Azed must record it now (debit the payables control account and ABC Ltd's account; credit purchases returns). Until it is posted, Azed's ledger overstates what it owes by $400.

Two differences you must never treat as timing differences: an invoice on the statement that you have no record of at all (it may belong to another customer, or the goods may never have arrived — query it before you pay it), and an invoice that appears on the statement twice.

7 FA1 exam focus — Chapter 6