What Are Accrued Expenses?
Accrued expenses are liabilities a company needs to account for, but for which no invoice has yet been received and no payment has been made.
An accrued expense, also known as an accrued liability, is an accounting concept. It 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. The matching principle is used to match these costs to revenue. It stipulates that revenues and their related costs must be recorded in the accounting period in which they occur. This is true regardless of whether cash was received by the seller or paid out by the buyer.
Accrued Expenses – A Closer Look
Accrued expenses are listed on a company’s balance sheet as current liabilities. As such, they indicate a company’s commitment to making a future cash payment. An accrued expense may even be listed as an estimate that may differ from the supplier’s invoice, which will arrive at a later date. Expenses are recorded when they are incurred, not when they are paid, according to the accrual method of accounting.
Consider a corporation that purchases products from a vendor but has not yet received an invoice for the transaction. This is an example of an accrued expense. Other types of accrued expenses include loan interest payments, warranties on items or services purchased, and taxes. All of these are liabilities that have been incurred but for which no invoices or payments have been received. Employee commissions, salaries, and bonuses are also accrued in the period in which they occur, but they are often paid in the following period.
Types of Accrued Expenses
A corporation may report many forms of accrued expenses in its financial statements. Salaries and wages payable, interest, and other expenditures such as loan interest or taxes are all examples of accrued expenses.
- Salary and wages payable – Salaries and wages payable refer to the account that records the money owing to employees for their efforts. Salaried employees are paid the same amount every pay period regardless of how much time they work. Wages refer to hourly employees whose compensation is based on the number of hours performed. The payable salary period might be weekly, bi-weekly, monthly, or bi-monthly. Often, an organization’s pay cycle ends before the accounting period. This requires accounting for future payments in the current accounting period. Compensation that is scheduled to be paid after the accounting period should be recorded as an accrued expense.
- Interest payable – Interest payable identifies any interest charges that a corporation has incurred but has not yet paid off. At the conclusion of the accounting period, the accrual entry is reported. The exact amount depends on how much interest has really been accrued on the loan.
- Other expenses – Other expenditures, such as utilities or taxes, are frequently treated as accrued expenses. This is because the obligation is incurred before the invoice arrives or the payment is made. For example, monthly utility bills or quarterly tax installments.
Accrual vs. Cash Basis Accounting
Cash basis accounting only records financial events and transactions when cash is transferred. This frequently results in overstatement and understatement of income and account balances. Conversely, the accrual method of accounting is time-consuming due to the extensive journaling required. However, it provides a more accurate picture of a company’s transactions and occurrences for each period. This more detailed picture enables financial statement users to better comprehend a company’s current financial status.
- Accrual accounting – refers to the system of accounting used to track a company’s profits, sales, and costs. It requires that expenses are recognized when they are incurred, not necessarily when they are paid. Accrual accounting enables for more accurate recording of obligations. This is because it considers all costs, both accrued and prepaid. Furthermore, accrual accounting may help a business better comprehend its past, present, and future transactions for each accounting period.
- Cash accounting – The manner of documenting transactions in cash basis accounting differs from accrual accounting. Accrual accounting records all transactions by matching expenses to the period they were incurred. Cash basis accounting simply records transactions that result in a cash exchange. Cash accounting is a simple methodology for documenting just cash transactions. However, it has the potential to result in an erroneous portrayal of account balances, revenue, profits, or losses.
Accrued Expenses versus Accounts Payable
Both accrued expenses and accounts payable are accounted for under Current Liabilities on a company’s balance sheet.
- Accrued expenses are expenditures that a corporation knows it must pay. However, they cannot since they have not yet been billed. Still, the firm accounts for these charges matching the obligation to the period it was incurred. As a result, management and shareholders have a clearer idea of what its overall obligations are. This also enables stakeholders to make more informed judgments about how management manages the money.
- Accounts payable are obligations for which invoices have been received, but have not yet been paid. Once an accrued expense receives an invoice, the amount is moved into accounts payable.
Accrued Expenses versus Prepaid Expenses
Prepaid expenses are the inverse of accrued expenses. They are payments made in advance for products and services that are expected to be given or utilized in the future. Prepaid expenses are assets on the balance sheet, whereas accrued expenses are liabilities.
A prepaid expense emerges from a company making advance payments. For example, products or services that will be received in the future. Prepaid expenses are originally represented as assets. However, their value is deducted from the income statement over time. Unlike traditional costs, the prepaid expense will provide something of value to the firm over the course of numerous accounting periods.
Example of Accrued Expenses
ClothesRUs is a retail clothing shop. They obtain inventory from their supplier near the end of the month. However, they have not received an invoice from the supplier by month-end when the company closes its books. ClothesRUs uses GAAP accounting principles and wants to appropriately record this expenditure in the month of receipt. The accounting staff records an expense in the inventory expense account with a debit for the amount that the supplier is expected to charge. Accounting also enters a credit to an accrued expenses liability account. Thus, if the inventory supplies cost $6,000, the journal entry would be a $6,000 debit to the inventory expense. Also, a $6,000 credit to the accrued expenses liability account. However, the $6,000 entry would be reversed the next month. It requires a credit entry to the inventory expense account and a debit to the accrued expense liability account.
The firm subsequently gets the $6,000 supplier invoice on the 5th of the following month. They record it routinely using the accounting software’s accounts payable module. The entry occurs as a debit to the inventory expense account and a credit to the accounts payable account. As a result, there is no new expenditure recognition. Rather, the obligation for payment simply transfers to the accounts payable account.
Frequently Asked Questions
How Are Accrued Expenses Accounted for?
An accrued expense is recorded on the books before it is paid. The expenditure is incurred and reported in the accounting period in which it is incurred. Accrued expenses are displayed on a company’s balance sheet as current liabilities. They are a liability because they indicate a company’s obligation to make a future cash payment.
What Are Examples of Accrued Expenses?
A common example is when a corporation purchases products from a vendor but has not yet received an invoice for the transaction, Other types of accumulated expenditures include loan interest payments, warranties on items or services purchased, and taxes. All of these obligations have been incurred or obtained but for which no invoices or payments have been received. Employee commissions, salaries, and bonuses are accrued in the period in which they occur, but they are often paid in the following accounting period.
How Does Accrual Accounting Differ From Cash Basis Accounting?
Accrual accounting documents a company’s performance and position by recognizing economic events regardless of when cash transactions occur. Cash basis accounting records transactions only when money is received. Accrual accounting provides a more precise representation of a company’s transactions and occurrences for each period. Cash basis accounting frequently causes income and account balances to be overstated and understated.
Up Next: What Is Deadweight Loss?
A deadweight loss is a societal cost caused by market inefficiency. It arises when supply and demand are out of balance. A deadweight loss is a term most commonly used in economics. However, it may be applied to any shortcoming created by poor resource allocation. Ultimately, it results in a reduction in potential revenue for people and businesses. Often it is the unwanted result of taxes and price restrictions limiting corporate development and recruiting capacity. For example, price ceilings, such as price restrictions and rent controls. Also, price floors, such as minimum wage and living wage legislation. Even taxation can result in deadweight loss. With a lower degree of commerce, a society’s resource allocation may become inefficient.