While simple in concept, properly accounting for accrued expenses can get complex in practice, but it is essential to create an accurate financial picture. Accrued expenses offer a better methodology to match revenues and costs within an accounting period to give a reliable view of profitability.
So, what is an accrued expense, and how can you use them to improve your financial reporting?
What are accrued expenses?
Accrued expenses represent costs incurred by a company for goods or services that have been received but have yet to be paid for. These are recorded in the company’s financial statements through adjusting entries, enabling the recognition of liabilities and expenses that still need to be received in invoice form.
Companies can better match revenues with their related expenses in the appropriate accounting period by recording accrued expenses. Accrued expenses provide a more accurate picture of the company’s profitability and financial position.
The importance of accrued expenses
Properly tracking accrued expenses enables companies to know all their outstanding liabilities. This helps ensure businesses don’t overextend themselves or take on more expenses than they can realistically afford.
A company needs visibility into unpaid vendor invoices and services to manage cash flow and prevent taking on excessive debt obligations. If a business loses track of accrued expenses, it may continue spending freely while unaware of large pending payments building up on its books. Maintaining an accurate record of accrued liabilities keeps companies financially responsible and careful not to overcommit funds.
Example of an accrued expense
Say a company called Web Design Co. completes a website design project for a client in April with net 60 payment terms. Web Design Co finishes the website after incurring $4,000 in contractor expenses and delivers it to the client on April 30. However, payment will not be made until June under the contract terms.
With accrual accounting expenses, Web Design Co. records the $5,000 as accrued revenue in April when the website was delivered, increasing accounts receivable. Web Design Co. also records $4,000 in contractor expenses to complete the website, increasing accrued expenses. This matches the revenue earned to the expenses incurred in April, even though cash has yet to be exchanged.
Accrued expenses hold many benefits to the company and are an integral part of accounting, so it’s essential to understand how they work.
How do accrued expenses work?
Despite its complexities, accruing expenses can be completed with a simple two-step accounting process.
First, when an expense is incurred but not paid, the company records an adjusting entry to debit the expense account and credit accrued liabilities. This increases expenses on the income statement and liabilities on the balance sheet.
Second, when payment is made, the company debits accrued liabilities and credits cash, reversing the original adjusting entry. This system enables businesses to capture expenses in real time when incurred rather than paid.
What are the different types of accrued expenses?
Accrued expenses are typically broken down into a few categories based on various situations. The most common types of accrued expenses include:
- Unpaid interest on loans: Interest expenses on loans that have been incurred but have yet to be paid.
- Employee compensation: Wages or salaries employees have earned but will be paid on the next payroll date.
- Unused vacation or sick days: If a company allows employees to roll over vacation or sick days, these liabilities represent a future cash outflow.
- Utilities for the month incurred: Utility expenses that have been used but not yet paid for (water, electricity, internet, etc.).
Services yet to be invoiced: These services have been used but not yet billed.
While many variations of accrued expense exist, they all typically come with similar advantages and disadvantages for businesses.
4 advantages and disadvantages of accrued expenses
When recording accrued expenses, it’s essential to understand the potential benefits and drawbacks.
Here are a few of the most impactful advantages of accrual basis accounting:
- Accurate financial reporting: Accrued expenses encourage better matches of revenues and expenses to show a more accurate picture of profitability in a given period.
- Tracked liabilities: Accurate expenses reflect liabilities and expenses that have been incurred but not yet billed or paid.
- Clear audit trail: Accrued expenses provide a clearer audit trail for improved financial transparency.
- Planning and budgeting: Accrued expenses enable better financial planning and budgeting when all costs are captured.
Companies should also consider any setbacks associated with accrued expenses.
Here are a few of the drawbacks of accrual basis accounting:
- Complex accounting: More complex accounting is needed to track and adjust unpaid expenses.
- Double-booked expenses: Errors can cause double-booked expenses if accruals are improperly reversed.
- Inaccurate estimates: Some accrued expenses require appraisals that need to be revised.
- Current cash flow: Relying entirely on accrual basis accounting can make determining your actual cash flow position harder.
Despite these drawbacks, roughly two-thirds of small businesses still use accrual basis accounting and, in some cases, cash basis accounting.
Accrual vs. cash basis accounting
It’s important for companies to understand the differences between cash basis accounting and accrual basis accounting.
With cash basis accounting, the moment cash exchanges hands is when revenue and expenses are recorded. So, instead of accounting for the transac