How do accounts payable differ from expenses?

September 10, 2015

Differences between accounts payable (balance sheet) and expenses (income statement) are sometimes confusing. In this article, we will discuss such differences and show how the two types of accounts can be connected in a journal entry.

1. Differences between accounts payable and expenses

The understanding of the flow of the accounting equation and knowing the location of each account on various financial statements is the essential part of answering the question about the difference between expenses and accounts payable. Concisely put, the difference is that an expense is an income statement account that becomes a part of the balance sheet through stockholders’ equity. The accounts payable, on the other hand, is a liability account that never touches the income statement and goes straight to the balance sheet.  Concise is good, but let’s spend some time looking at what that really means.

We all know that Assets = Liabilities + Stockholders’ Equity. From that, with a little bit of simple algebra, we can get to Stockholders’ Equity = Assets – Liabilities. Therefore, in the most straightforward of terms, stockholders’ equity, as a whole, communicates what would remain if the business were to liquidate all assets and use the money to pay off all liabilities.  By this logic, the higher the stockholders’ equity is, the healthier the business must be. Think about it in the same manner you would about your personal bank account and your credit card debt. If you were to use the cash in your bank account (asset) to pay off all of your credit card debt (liability), what remains is your money to keep or your personal equity.

Now, let’s take a closer look at stockholder’s equity specifically, as it does contain a couple of interesting components. Stockholders’ equity consists of two types of capital, contributed capital (such as common and preferred stock) and retained capital (such as retained earnings).  Stockholders’ equity account is increased through contributed capital whenever the stockholders contribute additional funds and, in exchange, the business issues them more stock. The more interesting of the two is the increase in retained capital or retained earnings. When the retained earnings account increases, it means that after earning revenues and spending money on expenses (see you knew we were getting there) and paying dividends to the stockholders, the business still has money remaining. Now this is the kind of health we want to see. It means the business is not only earning revenues through selling their products and services, but is also not overspending, thus generating a net income. Let’s remember that Revenues – Expenses = Net Income. So, as expected, expenses are in fact an Income Statement account and as expenses increase, net income decreases, therefore decreasing stockholders’ equity.  We have come full circle!

Time to move on to accounts payable. As we’ve mentioned before, accounts payable is a liability account.  A liability is a promise made by the business to make a payment of cash at a later time. In other words, liabilities indicate that we owe money to someone else. Let’s return to your personal credit card example. You know the cash you have put aside to pay the bill isn’t yours to keep, even if it’s still in your bank account. So liabilities do not touch stockholders’ equity directly, but do let the interested parties know that not all of our assets are ours to keep. We will have to use some of that cash at some point (depending on whether the liability is short-term or long-term) to pay off this liability.

Now let’s see if we can connect these two concepts into one journal entry. What happens when a business buys employee uniforms on account? The journal entry recorded by their accountant would be:

Account Titles

Debit

Credit

Uniform Expense

x

 

    Accounts Payable

 

x

This journal entry hits both an expense account and an accounts payable account. What it communicates is that we made a purchase and therefore had an expense that will take away from some of our earned revenues and therefore decrease our net income. We also made this purchase on account (instead of paying cash right away) and therefore our liabilities should increase, because we will be dispersing cash at a later time.

This is where knowing our T-accounts come in handy (debits on the left, credits on the right). Expense T-accounts carry a debit balance and are therefore increased through a debit. Expenses increased in the journal entry above. Per our earlier discussion, as expenses increase, our net income decreases thus decreasing our retained earnings/capital and our stockholders’ equity as a whole.  On the flip side of the equation, liability T-accounts carry a credit balance and are therefore increased through a credit. The liabilities also increased in the journal entry above, indicating that we will not have as much cash remaining for ourselves because of our promise to pay for the uniforms at a later date. Both an increase in expenses and an increase in liabilities point to the decrease in stockholders’ equity thus balancing the accounting equation. We’re using double entry accounting at its best to communicate the details of why this decrease in stockholders’ equity has indeed taken place.

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