If your company uses the accrual accounting basis rather than the cash basis, you’ve probably come across something called accrued expenses on your balance sheet.
For many, this raises a question: Aren’t expenses supposed to be listed on the income statement? What are they doing on the liability section of the balance sheet?
The answer here is yes, expenses are recorded on the income statement. But accrued expenses are costs you’ve incurred but haven’t paid yet, so they’re actually a liability.
In this article, we’ll dive into the nuances of accrued expenses. We’ll outline what they are, discuss how they work, and provide some real-life examples to help you get a practical handle on how to use accrued expenses.
What are accrued expenses?
Definition of accrued expenses
Accrued expenses are costs that your company has incurred but hasn’t yet paid for. They’re recognized in your financial statements when they happen, not when the cash actually leaves the business.
Say, for example, an employee works in December, but their salary is paid in January. In this case, the salary for that employee’s work in December would be recorded as an accrued expense.
Accrued expenses are important for accurate financial reporting.
They ensure that your company’s income statement reflects the true costs of running the business during the period in question, even if no money has left the company’s bank account yet. It’s part of the broader concept of the accrual accounting basis, where timing and matching are critical.
Accrual vs. cash basis accounting
In accrual accounting, you record income and expenses when they are earned or recorded, regardless of whether cash has been received or paid.
You’ll see these entries show up as accrued revenue and accrued expenses.
In cash basis accounting, you record income and expenses only when cash changes hands.
This has some important implications for reporting.
The accrual method allows businesses to match expenses to the revenues they help generate and create a more realistic picture of financial health.
Accrued expenses vs. prepaid expenses
In understanding what accrued expenses are and how they work, it's important to know a little bit about their inverse: prepaid expenses.
Accrued expenses are costs you’ve incurred but haven’t paid for yet. Prepaid expenses are costs you’ve paid in advance for a product or service you’ll receive in the future.
For example, if you pay one year’s worth of rent up front, you’ve prepaid your rent expense. Each month, the portion of that rent that relates to the period in question (one-twelfth of the annual cost) is recognized as an expense.
How accrued expenses work
In accrual accounting, expenses are recognized when they are incurred, not when the cash is paid.
Using this principle, accountants ensure that financial statements reflect the true costs associated with generating revenue during the period they’re reporting for.
This is known as the matching principle.
Following the matching principle gives a more accurate view of profitability and performance, especially over shorter timeframes like monthly or quarterly reporting.
How do you record accrued expenses?
Let’s walk through the process of recording accrued expenses.
First, you incur the expense. Your company consumes a good or service, such as receiving components for manufacturing or using your water utility. You’ve used the good or service, but you haven’t paid for it yet.
Next, you record the expense. In the general ledger, you increase (debit) the relevant expense account and credit the accrued expenses payable liability account.
When you pay for the expenses, the liability is settled. You debit the accrued expenses payable account (removing the liability from the balance sheet) and credit the cash account to reflect the cash outflow.
Accrued expenses’ impact on cash flow management
Accrued expenses impact the company’s profitability on paper, but they don’t immediately impact cash flow since you’ve not yet actually paid for the expenses.
This can make things a little tricky.
Accrued expenses increase reporting expenses but don’t decrease cash right away. This creates a timing gap between when the expense shows up on the books and when it actually affects the bank account.
This can make financial statements somewhat misleading if not monitored. If a company focuses solely on cash flow and ignores accrued liabilities building up, it may overestimate its financial health.
The use of accrued expenses has some important implications for cash flow planning.
By deferring payment, businesses can manage short-term liquidity more effectively. This is especially helpful during seasonal dips or lean months.
But, delaying payment doesn’t eliminate the obligation. Businesses must ensure they have enough cash when the expense becomes due or risk running into cash shortfalls.
Examples of accrued expenses
What classifies as an accrued expense?
The answer here is really any expense that you incur without yet paying for. However, there are a few common costs that businesses are likely to incur prior to paying. These include:
- Salaries and wages
- Interest on loans
- Utilities (e.g., electricity, water, gas)
- Rent (when payment is due after the service period)
- Taxes payable
- Bonuses and commissions
- Legal fees
- Consulting or contractor services
- Maintenance and repair costs
Let’s illustrate with a few practical examples.
1. Accrued salaries
Say a company’s pay cycle is biweekly, but the month in question ends on a Wednesday.
This means that three days of work fall into the current month but won’t be paid out until the next payroll cycle.
The company accrues the wages for those three days in the current month’s books to reflect the labor costs incurred, even though cash payment will occur in the next month.
2. Accrued utilities
Say a business receives its electricity bill on the 10th of each month, which covers usage from the previous month.
At the end of the month (before the bill arrives), your accountant estimates and records the electricity cost as an accrued expense so that your profit and loss statement reflects the true cost of operations for that month.
3. Accrued interest expense
Say a company has a loan that accrues interest daily but that only needs to be paid quarterly.
Even though no payment is due until the end of the quarter, the company records interest expense each month as it accrues, increasing both interest expense on the income statement and accrued liabilities on the balance sheet.
How accrued expenses appear on financial statements
Accrued expenses have important impacts on the three main financial statements:
- Income statement: Accrued expenses are recorded as operating expenses (or another appropriate category) in the period they are incurred, even though they have not yet been paid.
- Balance sheet: Accrued expenses are recorded as current liabilities, typically under a label like accrued expenses, accrued liabilities, or a specific expenses category such as accrued interest.
- Cash flow statement: Accrued expenses do not appear on the cash flow statement when they are incurred, but they do show up when the cash is actually paid for the expense and the appropriate adjusting journal entries are made.
Track accrued expenses in real time
Accrued expenses are an important part of accrual-based accounting.
They help us ensure that financial statements accurately reflect the costs of doing business in the financial period for which we’re reporting.
To improve reporting accuracy and timeliness, many finance leaders turn to specialized financial operations software tools like BILL.
With BILL, you can:
- Track and monitor expenditure in real time
- Create reporting dashboards to keep an eye on key metrics (like accrued expenses)
- Integrate seamlessly with other financial tools, such as your accounting solution
Get started with BILL today.
