Early Payment Discounts vs. Need for Cash
Some vendors offer an early payment discount such as 2/10, net 30. This means that the buyer may deduct 2% of the amount owed if the vendor is paid within 10 days instead of the normal 30 days. For instance, an invoice amount of $1,000 can be settled in full if the buyer will pay $980 within 10 days. In this example, the buyer will save $20 (2% X $1,000) for paying 20 days earlier than the normal due date. If the buyer has the opportunity to do this every 20 days, it would occur 18 times during a year (365 days divided by 20 days = 18 times). That means the company could save up to $360 ($20 X 18 times per year) each year by using a single $980 amount. Hence the annual percentage rate is approximately 36% ($360 earned divided by $980 used).
Looking at it another way, if the buyer had to borrow $980 from its bank for the 20 days at a borrowing rate of 6% per year, the interest for 20 days would be only $3.22 ($980 X 6% X 20/365). By paying $3.22 of interest to the bank, the buyer will save paying the vendor $20 and therefore will be better off by $16.78 ($20.00 minus $3.22). If this occurs 18 times in a year, the net annual savings will be approximately $301 [$16.78 X 18 times; or $360 per year saved minus the annual interest paid to the bank of $59 ($980 X 6%)].
A discount of 1% for paying 20 days early equates to an annual interest rate of approximately 18%.
It is clear that buyers with sufficient cash balances or a readily available line of credit should take advantage of the early payment discounts. However, some buyers are operating with very little cash and are unable to borrow additional money. These buyers may be wise to forgo the early payment discounts in order to avoid the risk of overdrawing their checking account. One overdraft fee could be greater than the early payment discount. If an overdraft causes several of the buyer's checks to be returned to its vendors, the total amount of overdraft fees will be even greater.
If a buyer's checks are returned because of insufficient funds its suppliers may become concerned about the buyer's ability to pay. This could lead to one or more of the suppliers demanding payment at the time of delivery. The elimination of 30 days of credit from suppliers could be devastating for a buyer with little money and a credit line that has been exhausted.
Be sure to consider your company's cash balances and cash needs before paying invoices prior to their due dates.
Vendor or employee?
Occasionally an individual will provide services for a company and submits an invoice. The invoice is processed through accounts payable and in the U.S. the company may be required to issue the individual an IRS Form 1099-NEC in January of the following year.
While the company views the individual as an independent contractor, the Internal Revenue Service rules may dictate that the individual is actually a part-time employee. If a person is deemed to be an employee, the Internal Revenue Service requires that payroll taxes be withheld and a Form W-2 be issued instead of Form 1099-NEC.
You can learn more about the distinction between an independent contractor and an employee at www.IRS.gov.
In order to protect a company's assets it is important that a company have in place a variety of controls over issuing purchase orders, issuing checks, adding vendors to the accounts payable master vendor file, segregating duties, and other safeguards referred to as internal controls.
We recommend that a professional who is well-versed in internal controls perform a review of your company's policies and procedures.
Batching the payments to vendors
In order for the accounts payable staff to operate efficiently, it is helpful to process the checks written to vendors only on specified days each month. Writing the checks on pre-announced days will hopefully discourage the need for "rush" checks and allow the accounts payable processing to be more efficient.
Sales and use taxes
Certain purchases of goods and/or services may be subject to state sales taxes. If a sales tax is not paid for the sales-taxable goods or services (even from out-of-state vendors), the buyer is likely to be liable for a state use tax. To further complicate the situation, some organizations may be exempt from both a sales tax and a use tax depending on the state laws.
The responsibility for compliance with sales and use taxes rests with each company. As a result, companies must be familiar with the laws of the states in which they operate.
Travel and entertainment
Travel and entertainment, commonly known as T&E, is another area of accounts payable that needs to be managed. Here, too, each company must establish procedures and controls and be in compliance with Internal Revenue Service (IRS) rules which can be found at www.IRS.gov.