Question

A company has a December year end and creates checks to pay their vendors towards the end of the month. The company creates all the proper journal entries at the time of creating the checks, but they do not mail the checks until January. Explain which, if any financial ratios are affected by this decision. Explain why this decision would be made?

Answer 1

All the journal entries have been passed which means the journal entry for the payment to vendors is also posted. This will reduce the accounts payable value in the ledger. The checks are not paid in reality, the accounts payable should not be decreased. Thus the accounts payable will remain undervalued which in turns makes the average accounts payable undervalued.

The ratio which will be majorly impacted is the Accounts Payable turnover.

Accounts Payable turnover = Credit purchase/Average accounts payable

Now dividing the Credit purchase with an undervalued average accounts payable will inflate the Accounts Payable turnover. As a result Days' in Accounts Payable will also become more. This will show that the company enjoys credit from its vendor for more number of days than actual.

This decision is taken to attract vendors to allow then credit for more number of days by showing that its existing vendors allow them larger credits.

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