What are accrued expenses (accrued liabilities)?
– Definition: Accrued expenses are obligations for goods or services that a company has received or used but has not yet paid for. They are recorded in the period the cost is incurred, even though cash will be paid later.
– Presentation: Because they represent future cash outflows, accrued expenses are reported as current liabilities on the balance sheet.
Why accruals matter
– Accrual accounting recognizes transactions when they occur rather than when cash changes hands. That timing gives a clearer picture of performance and obligations for a reporting period.
– Most large companies and financial reporting standards require accrual accounting because it matches revenues and expenses to the periods in which they belong.
Key definitions
– Accrued expense (accrued liability): An expense recorded before payment is made.
– Prepaid expense: A payment made in advance for benefits that will be consumed later; recorded as an asset until used.
– Accrual basis accounting: Accounting method that records revenues and expenses when earned/incurred, not when cash is exchanged.
– Cash basis accounting: Accounting method that records transactions only when cash is received or paid.
How accrued expenses are recorded — step-by-step
1. Identify an obligation incurred before period-end (e.g., work performed, utilities used).
2. Estimate the amount if the exact invoice hasn’t arrived.
3. Record the adjusting journal entry at period-end:
– Debit the appropriate expense account (increases expense on the income statement).
– Credit a payable or accrued liability account (increases current liabilities on the balance sheet).
4. When the invoice arrives or payment is made, clear the accrual:
– If the invoice equals the accrual: debit the liability and credit cash when paid.
– If the invoice differs: adjust expense and liability for the difference.
5. Use a reversing entry at the start of the next period if helpful:
– Reverse the accrual entry to avoid recording the same expense twice when the supplier invoice is posted.
Simple numeric example (wages)
Assumption: The payroll week ends December 31. Employees earned $12,000 for that week but payroll is paid on January 5.
– December 31 adjusting entry:
– Debit Wage Expense: $12,000
– Credit Accrued Wages (or Wages Payable): $12,000
Effect: Expenses increase by $12,000 (reducing net income); current liabilities increase by $12,000; cash unchanged.
– January 5 when payroll is paid:
Option A — if you used a reversing entry on Jan 1:
– Jan 1 reversing entry: Debit Accrued Wages $12,000; Credit Wage Expense $12,000
– Jan 5 payment entry: Debit Wage Expense $12,000; Credit Cash $12,000
Result: Expense is recorded once (on Jan 5) and cash is reduced when paid.
Option B — if not reversing:
– Jan 5 payment entry: Debit Accrued Wages $12,000; Credit Cash $12,000
Common types of accrued expenses
– Salaries, wages, and payroll taxes
– Interest on loans (accrued interest)
– Utilities used but not yet billed
– Taxes incurred but unpaid (income tax, property tax)
– Commissions and bonuses earned but unpaid
– Warranty obligations and estimated legal costs
– Consulting or contractor services performed but not invoiced
Practical month-end checklist for accrued expenses
– Payroll: calculate unpaid days or hours through period end.
– Interest: compute interest accrued on loans for the period.
– Utilities and rent: estimate unbilled amounts.
– Taxes: accrue income and payroll taxes applicable to the period.
– Bonuses/commissions: accrue amounts earned by employees or agents.
– Contracts and retainers: review service contracts for earned but unpaid fees.
– Contingent liabilities: evaluate legal claims and warranty reserves for probable losses.
– Documentation: attach support (calculation spreadsheets, contractual terms) to each accrual entry.
– Reversals: mark entries that should be auto-reversed or flagged for manual reversal.
Advantages and disadvantages (concise)
Advantages
– Better matches expenses to the period they relate to, improving comparability and decision usefulness.
– Produces smoother month-to-month results by recognizing recurring costs even if cash timing varies.
– Aligns with GAAP and other reporting frameworks that prefer accrual accounting.
Disadvantages
– Requires estimates and judgment, increasing the risk of error or bias.
– More administrative work and accounting entries than cash-basis bookkeeping.
– Can obscure cash flow since expenses recorded may not yet affect bank balances.
Reversing entries — quick tip
– Use reversing entries for temporary accruals that will be paid early in the next period (payroll, small recurring bills). This avoids duplicate expense recognition when the vendor invoice posts.
Example of an interest accrual (brief)
– Loan accrues $250 interest for December but interest is payable next month.
– Dec 31: Debit Interest Expense $250; Credit Interest Payable $250.
– When paid: Debit Interest Payable $250; Credit Cash $250.
Assumptions and limitations
– Accruals rely on reasonable estimates when invoices are not available; controls and documentation are needed to reduce errors.
– Accrual amounts should be updated when actual invoices arrive; differences must be reconciled.
Sources and further reading
– Investopedia — Accrued Expense: https://www.investopedia.com/terms/a/accruedexpense.asp
– Financial Accounting Standards Board (FASB): https://www.fasb.org
– U.S. Securities and Exchange Commission (SEC) — financial reporting resources: https://www.sec.gov
– American Institute of CPAs (AICPA): https://www.aicpa.org
Educational disclaimer
This explainer is for educational purposes only and does not constitute financial, accounting, or legal advice for your specific situation. For company-specific accounting guidance or tax consequences, consult a licensed accountant or qualified professional.