Accrued expenses of a company are incurred expenses that are yet to be paid off - for example, when a business receives goods or services and pays for them at a later date. Accurately tracking and accounting for such expenses, as well as budgeting accordingly, will help you better understand where your company stands financially. Let’s take a closer look at what accrued expenses are and how to record them on the balance sheet.
Highlights/ Key Takeaways
- Accrued expenses are expenses that have already been incurred but for which no billing documentation has been received.
- Such expenses are recorded as journal entries in the process known as “accrual accounting.”
- As opposed to simple cash-basis accounting, the accrual method of accounting requires more records but provides a more accurate financial picture.
- Salaries and wages, utility payments, interest on loans and other debt obligations, and taxes to be paid are all common examples of accrued expenses.
What Are Accrued Expenses?
Accrued expenses on a balance sheet are any expenses incurred by a company that have not been paid for yet. Accrued expenses have no associated expenditure documentation yet, - instead, a journal entry must be created to record the expense value, as well as an offsetting liability.
Most of the time, these journal entries are created as an automatic reversing entry, meaning that the accounting software automatically creates an offsetting entry as of the first day of the following month. Once the supplier submits an invoice to the company, it cancels out the reversed entry.
Types of Accrued Expenses
Any business expense that is recorded now but paid for at a later date requires an accrued expense entry in your books. Some common types of accrued expenses are:
- Salaries and wages. Accrued salaries refer to the unpaid amount of liability for salaries that have been earned by employees but have not been paid to them yet.
- Utilities. Any utilities used for the month are recorded as accrued expenses before an invoice is received and paid for that period.
- Interest. Similarly, the amount of interest on a loan that has already been incurred but has not yet been paid out must be recorded as an accrued expense.
- Taxes. Most taxes are paid at the end of the year, which means they will present accrued expenses until paid out.
Accrued Expenses Example
To better understand the concept of accrued expenses, let us take a look at a specific example.
Suppose Company ABC pays its employees’ salaries on the first day of each month for the work they completed in the previous month. So, employees that worked all of December will receive their December salary on January 1st.
As of December 31st, the company has not paid employees’ salaries for the services provided from December 1st to December 31st. However, if ABC’s income statement recognizes only the salary payments that have been made, it will not accurately represent what the company owes for the services already rendered by its employees.
As such, an adjusting journal entry must be recorded at the end of the accounting period for the expenses incurred in the last month. The journal entry will be dated December 31st and will be recorded as a credit to the salaries payable account on the balance sheet and a debit to the salaries expenses account on the income statement.
Accrual vs Cash Basis Accounting
Tracking and recording accrued expenses is a part of the process called “accrual accounting.” This type of accounting measures the financial performance of a company by recognizing economic events even before the actual cash transaction occurs.
Accrual accounting often requires extensive journal entries and is more labor-intensive. However, it presents a more accurate measure of a company’s events and transactions for each reporting period. This more detailed picture helps the readers of financial statements to better understand a company’s current and future financial position.
Cash basis accounting, on the other hand, records financial events and transactions only when cash is exchanged. This often leads to understatement or overstatement of income and account balances.
When Should You Accrue an Expense?
Every time your company incurs an expense that is not immediately paid for, it must be accrued, meaning you must create a journal entry, as well as an offsetting entry. Doing so will help you to keep track of how much a business owes to employees, suppliers, or the tax authorities.
In accrual accounting, revenue is recorded whenever it is earned, regardless of when it is actually received. At the same time, expenses are recorded when they are incurred, regardless of when they are paid.
Why Are Accrued Expenses Important?
Accurately tracking a company’s accrued expenses can provide a more accurate financial picture than simply recording cash transactions that have already occurred. Accrual accounting ensures that non-cash transactions are also accounted for, even before they impact bank accounts.
For large companies with numerous accrued expenses, properly recording them as journal entries can help the management and financial analysts to better understand the company’s profitability and the future cash flows associated with such expenses.
Advantages and Disadvantages of Accrued Expenses
While accrued expenses allow the company to more accurately record the current and future transactions, accrued accounting does somewhat complicate the financial reporting process. Accrued expenses have both advantages and disadvantages - but you might not have a choice but to record them, as it is required for some types of businesses.
Advantages of Accrued Expenses
- Adhere to external financial reporting requirements
- May provide more useful and accurate information for management
- Allow to keep track of spending and more accurately budget for upcoming expenses
- Potentially make financial reporting more aligned with actual business operations
- Often make month-over-month financial statements more consistent
Disadvantages of Accrued Expenses
- More time- and labor-intensive to prepare as compared to the cash-based accounting method
- Might complicate financial reporting by blurring the line between cash and non-cash transactions
- More complicated accounting nature increases the risk of errors
Accrued Expenses vs Accounts Payable and Prepaid Expenses
While similar in nature, accrued expenses, accounts payable, and prepaid expenses are different accounting concepts. Understanding the difference between these three accounts is critical to accurately preparing business financial statements.
What’s the Difference between Accrued Expenses and Accounts Payable?
Recall that accrued expenses are expenses that have already been incurred but have no billing documentation or invoices issued yet.
Accounts payable, on the other hand, are obligations to pay the money owed based on invoices received from suppliers that are already recorded in the accounting system.
As such, the two main differences between accounts payable and accrued expenses are:
- An accrued expense has no supporting supplier invoice. An account payable item must be supported by an invoice.
- An accrued expense must be an expense, while an account payable may not be an expense.
Example of Accrued Expenses vs Accounts Payable
One common example of an accrued expense is utility payments. When you use utilities throughout the month, the bill or invoice is only issued the following month. This makes the value of utilities owed an accrued expense.
On the other hand, an account payable might be to pay an invoice for a piece of equipment that has been delivered by the supplier. This piece of equipment is a fixed asset and is, therefore, not classified as an expense. However, it will eventually be written off as an expense through ongoing depreciation.
What’s the Difference between Accrued Expenses vs Prepaid Expenses?
Unline an accrued expense, with a prepaid expense, the liability is paid off before the actual asset or service has been rendered. In other words, prepaid expenses and accrued expenses are opposite in nature, with prepaid expenses appearing whenever a company makes advanced payments for services or assets that it has not yet received.
Therefore, a prepaid expense will initially appear as a current asset on the financial statement. Its value is then expensed onto the income statement over time: unlike traditional expenses, prepaid expanses provide something of value to the business over the course of several accounting periods.
Example of Accrued Expenses vs Prepaid Expenses
Let’s revisit our utility payment example. When you use utilities throughout the month but are only invoiced for them the following month, this is recorded as an accrued expense.
On the other hand, suppose a company pays monthly rent for the office on the 1st day of each month, covering the cost of the rent for the upcoming month. In that case, the rent payment will be recorded as a prepaid expense, since the rent is covered for a future period of time.
How to Calculate Accrued Expenses
Accrued expenses can be calculated in several ways, with the Percentage of Completion and Installment Methods being the most common ones.
Percentage of Completion Method
The Percentage of Completion Method is an accounting method, in which expenses and revenues for long-term contracts are calculated as a percentage of the work completed during the period.
This method is most commonly used by construction companies that are contracted to work on buildings, public sector infrastructure, energy facilities, and other long-term physical objects.
Percentage of Completion Method Example
Suppose Company ABC hires a construction company for an apartment building project. If the project is 20% complete in the first year, 20% of the total project cost will be recorded as an accrued expense for that year.
An installment sale is a financial agreement, in which the seller allows the buyer to make payments for an extended period of time. The buyer receives the product at the beginning of the installment period, while the number and the exact amount of each installment are agreed upon in advance.
Most commonly, the revenues and expenses associated with installment sales are recognized at the time of cash collection, and not at the time of sale. However, the expenses can also be recorded as accrued expenses until the money is finally collected.
Installment Method Example
Suppose a company buys a laptop with an installment plan. The laptop costs $500, which is spread over five months with equal installments. At the beginning of each month, the company will pay $100 to cover the installment owed for the previous month. Until the installment is paid, the amount of $100 will be recorded as an accrued expense.
Recording Accrued Expenses
For companies, it is important to keep track of accrued expenses, such as rent, salaries, and utilities. You can track expenses in one of the following ways:
- Accounting software. Most accounting tools will allow you to create a special account for accrued expenses, where you will be able to record how much you owe and when the payments are due.
- A spreadsheet or journal. You can also create a list of your accrued expenses in a simple spreadsheet or journal. This method is useful when you want to get a clear overview of the company’s accrued liabilities and their deadlines.
The basis of accounting for accrued expenses involves debiting whatever the expense may be and crediting that amount to the accrued expenses account. Usually, this entry is set to automatically reverse in the next reporting period, to be replaced by the supplier invoice that did not arrive in the previous period.
Note that when recording accrued expenses in the journal, it is important to enter the correct accrual date. This will usually be the date when the expense was incurred rather than the date it is paid on.
Examples of How to Record Accrued Expenses
The following examples explain how to record different types of accrued expenses:
- Benefit liability incurred; no supplier invoice as of the end of reporting period: debit to employee benefits expense, credit to accrued expenses.
- Employee salaries earned but not paid as of the end of reporting period: debit to wages expense, credit to accrued expenses.
- Inventory received; no supplier invoice as of the end of reporting period: debit to inventory expense, credit to accrued expenses.
- Income taxes accrued based on income earned: debit to income tax expense, credit to accrued expenses.
While the first three items would reverse the following month, income taxes remain “accrued” until paid, which is often at the end of a year.
Sample Accrued Expenses Journal Entry
Suppose Company ABC has paid interest on an outstanding loan of $500,000 for the month of March on April 5th. The interest is 2% per month, which means that ABC owes $500,000 x 0.02 = $10,000 in interest for March. This interest amount is paid off on April 5th.
The following journal entry will be recorded to account for the accrued interest expense:
|March 31st, 2023||Debit||Interest Expense||$10,000|
Once the owed interest is paid off on April 5th, the previous accounting entry will be reversed, and the following accounting entry will be recorded.
|April 5th, 2023||Debit||Interest Payable||$10,000|
Tracking and Managing Accrued Expenses
Tracking and managing accrued expenses may seem like a complicated task, but it can be considerably simplified with careful planning, attention to detail, and help of technology.
- Regularly review and reconcile accounts. If your company is small, the owner themselves should review and reconcile accounts. For larger organizations, a dedicated employee should act as a second set of eyes on the numbers.
- Double-check accrued expense reversals. While journal entries associated with accrued expenses are often reversed automatically in the next accounting period, make sure to double-check your transactions.
- Stay up-to-date with payment obligations. Ensure that you are paying off the bills as you planned and on time, staying within your budget.
- Follow a detailed checklist and calendar. Prepare a calendar and a detailed checklist for processing and recording transactions, including accrued expenses.
- Use specialized software. Many software programs allow to significantly simplify accrual accounting and automate the process of managing accrued expenses. Don’t hesitate to take advantage of it!
To recap, the accrued expenses meaning describes the expenses already incurred by a company, but for which an invoice has not yet been issued. While some types of businesses may get away with simpler cash basis accounting, others are required to record accrued expenses in a special journal, - so make sure to review and follow the external reporting regulations for your type of company.