Accrued Expenses

What are Accrued Expenses?

Definition: Accrued expenses are costs that are incurred in the current period but not paid for until the next period. In other words, it’s an expense that the company has benefited from but hasn’t paid for or recorded yet. This is why an accrual is recorded as a liability at the end of a period. It’s the amount of expenses owed to another company.

An accrued expense is an accounting term that refers to an expense that is recognized on the books before it has been paid; the expense is recorded in the accounting period in which it is incurred.. Because accrued expenses represent a company’s obligation to make future cash payments, they are shown on a company’s balance sheet as current liabilities; accrued expenses are also known as accrued liabilities. An accrued expense is only an estimate, and will likely differ from the supplier’s invoice that will arrive at a later date.

Following the accrual method of accounting, expenses are recognized when they are incurred, not necessarily when they are paid. Unless an expense is substantial, it is generally not accrued because accrual accounting requires the work of multiple journal entries.

What Does Accrued Expenses Mean?

The most common form of accruals is a monthly expense like rent or utilities that are consumed throughout the month and paid for on first of the following month. Let’s take rent for example. The business benefits from the rent expense all month, but it doesn’t actually pay for it until the next month. According to the accrual basis of accounting, expenses must be recorded when they are incurred, not necessarily when they are paid. Thus, the business should record an expense for its rental costs in the current month even though it hasn’t actually paid the rent yet.

The term accrues means to accumulate. When a company accrues expenses, it means that the portion of the unpaid bills is increasing. Accrual concept of accounting states that all the inflows and outflows should be recorded when they occur. This is done irrespective of whether actual cash is paid or not.

It is the expense recognized in the books before actual payment is made. Examples of accrued expenses include utilities used for an entire month but when the bill is received at the end of the month. Workers who work for the entire period but payment is made to the employees at the end. Services and goods consumed but no invoice received.

Example

Calvin’s Design Studio rents out a design space in a downtown apartment complex for $2,000 a month. Each rent payment is due on the first of the month for the prior month’s rent. This means that Calvin’s December month’s rent is due in January.

At the end of the year, Calvin’s income statement only shows 11 monthly rent payments because his December month’s rent hasn’t been recorded yet. This income statement is obviously misstating his rent expense for the year because he incurred 12 months worth of rental costs.

An adjusting journal entry is recorded at the end of the accounting cycle to accrue the December rent expense by debiting the rent expense account and crediting the accrued expense liability account. This journal entry records the rental costs for the month as well as the amount of month that Calvin owes his landlord at the end of the year.

Here are some common examples of expenses that can be accrued:

  • Interest on loan(s)
  • Goods received
  • Services received
  • Wages for employees
  • Taxes
  • Commissions
  • Utilities
  • Rent

Accrued Expenses vs Accounts Payable Differences

Accrued expenses and accounts payable are two important terms recorded in the balance sheet of organizations. The key difference between these terms is that accrued expense is recognized in the accounting books for the period it is incurred in whether cash is paid or not. Accounts payable is the payment to creditors who have made sales to the company on credit.

Accrued expenses are expenses a company knows it must pay, but cannot do so because it has not yet been billed for them. The company accounts for these costs anyway so that the management has a better indication of what its total liabilities really are. This will allow the company to make better decisions on how to spend its money.

Accounts payable are debts for which invoices have been received, but have not yet been paid.

Both accrued expenses and accounts payable are accounted for under “Current Liabilities” on a company’s balance sheet.

Once an accrued expense receives an invoice, the amount is moved into accounts payable.

Recording an Accrued Expense

Without an adjusting entry to accrue the interest expense that was incurred by the company in December, the company’s financial statements as of December 31 will not be reporting the $2,000 of interest (one-third of the $6,000) that the company has incurred in December. In order for the financial statements to be correct on the accrual basis of accounting, the accountant must record an adjusting entry dated as of December 31. The adjusting entry will consist of a debit of $2,000 to Interest Expense (an income statement account) and a credit of $2,000 to Interest Payable (a balance sheet account).

Is an Accrued Expense a Debit or Credit?

Debits and credits are used in a company’s bookkeeping in order for its books to balance. Debits increase asset or expense accounts and decrease liability, revenue or equity accounts. Credits do the reverse.

When recording a transaction, every debit entry must have a corresponding credit entry for the same dollar amount, or vice-versa.

Let’s give an example, using the Stonemill company again.

Stonemill reaches the end of August, and its employees have done work that they have not yet been paid for. The amount of the unpaid wages totals $31,000. This would be considered an accrued expense. As such, Stonemill’s’ bookkeeper would:

  • Debit $31,000 to “Wage Expenses” (reflected on a company’s income statement under “Operating Expenses”)
  • Credit $31,000 to “Wages Payable” (this would show up under “Short Term Liabilities” on the balance sheet).

Advantages of Accrued Expenses on Balance Sheet

  • It helps in the proper measure of the performance of a business during a reporting period as its accounts for the expenses incurred (although not due to be paid) with the associated revenues of the reporting period.
  • It helps in avoiding misstatement of the financial performance of the business.
  • It enables various stakeholders to better analyze the business performance and also gain more confidence of Investors as the same is GAAP compliant.

Limitations

  • Accrual Expenses reported by business are based on estimates and actual liability may vary from the estimates.
  • It can be used as a tool to suppress income and reduce taxes by the business.

Summary

  • Accrued expenses are recognized on the books when they are incurred, not when they are paid.
  • Accrual accounting requires more journal entries that simple cash balance accounting.
  • Accrual accounting provides a more accurate financial picture than cash basis accounting.

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