What is an example of payment in accounting?

A Simple Example of Payment in Accounting: The Bag Deal

Understanding the flow of money within a business is crucial. Accounting provides the framework to track these transactions, and payments are a core component. Let’s illustrate a straightforward payment scenario using two fictional companies: Bags Unlimited (the seller) and Company B (the buyer).

Imagine Bags Unlimited manufactures and sells various types of bags. They receive an order from Company B for 100 nylon bags. Upon shipment or delivery, Bags Unlimited doesn’t immediately receive cash. Instead, they issue an invoice to Company B. This invoice details the agreed-upon price for the 100 bags and sets a payment deadline, say, December 15th.

This seemingly simple action triggers a series of accounting entries. For Bags Unlimited, the invoice creates an accounts receivable. This represents the money owed to them by Company B. It’s an asset because Bags Unlimited expects to receive this payment in the future. Think of accounts receivable as a promise of payment.

On Company B’s side, the invoice creates an accounts payable. This reflects the money they owe to Bags Unlimited. It’s a liability because Company B has a future obligation to pay. Accounts payable essentially represents a promise to pay.

Until December 15th, the transaction remains unsettled. The invoice represents an open transaction reflected in both companies’ books. The payment, when made by Company B and received by Bags Unlimited on or before the due date, completes the cycle. This payment will reduce Bags Unlimited’s accounts receivable and simultaneously reduce Company B’s accounts payable. Both companies will record the payment transaction in their respective accounting systems, effectively closing out the open invoice.

This simple example of a bag purchase showcases how a typical payment transaction creates both an accounts receivable for the seller and an accounts payable for the buyer. These entries remain on the books until the payment is made, completing the transaction cycle and reflecting the actual flow of funds between the two businesses. This foundational principle underscores the importance of accurate and timely recording of payments in maintaining a clear and accurate picture of a company’s financial position.