What are accrued expenses?
An accrued expense signifies a financial obligation incurred by a company for goods or services that have been received but not yet paid for. It is recorded as a liability on the balance sheet, representing a future payment commitment. This is a fundamental concept in accrual accounting, where expenses are recognized at the time they are incurred, irrespective of when the cash transaction occurs.
Accrued expenses vs. prepaid expenses
Accrued expenses and prepaid expenses are two sides of the same accounting coin, differentiated by the timing of the payment in relation to the services received. Accrued expenses, such as accrued rent, are the result of receiving a service or goods before payment is made, creating a liability. Conversely, prepaid expenses are the result of receiving a service or goods after payment is made, creating an asset. Summarized, accrued expenses are incurred but yet to be paid whereas prepaid expenses have been paid but are yet to be realized.
Accounting for accrued expenses
Accrual basis vs. cash basis
Entities following US GAAP reporting requirements must use the accrual basis of accounting. The matching principle is one of the basic concepts within accrual accounting. This is the idea that revenue and expenses are recognized in the period they occur, not necessarily when they are paid (ie, the expense is recognized once the good or service purchased has been used). If an entity receives a good or service, they must recognize the benefit of having done so, even if they have not made a payment. They do this by recording an accrued liability and recognizing an expense over the period of use. At the end of the period of use and once the payment is made, the liability is relieved in full.
On the other hand, an entity using the cash basis of accounting recognizes expenses in the same period the payment is made and does not attempt to match the cost of a good or service to the usage period. Using cash basis, an organization would not expense the purchase until the payment is made, and would do so for the full amount of expense. Therefore there would not be any accrued liability recognition.
Overall, the accrual basis of accounting provides a more accurate measure of a company’s financial health than the cash basis of accounting, which is why the accrual basis is required for compliance with US GAAP.
Accrued expenses vs. accounts payable
While accrued expenses (and the associated accrued liability) and accounts payable are both liabilities, they represent two different types of treatment for an organization.
- Accrued expenses: Associated with obligations owed by a company for services delivered/received, but that have not been invoiced or billed.
- Accounts payable: Associated with obligations owed that a company has been invoiced for.
Financial statement presentation
Balance sheet recognition
When approaching the classification of accrued expenses/liabilities on the balance sheet, the utilization period needs to be considered. If the entirety of the service period and associated payment is within 12 months, the associated liability is short-term. Generally, accrued expenses and their corresponding liability are classified as current liabilities since the payments are typically due within a year.
Income statement recognition
As previously discussed, under the accrual method of accounting, accrued expense is recorded throughout the service period, and recognized on the income statement in conjunction with the associated accrued liability on the balance sheet.
Accrued expenses accounting treatment and journal entries
There are two main components of accounting for accrued expenses:
- The initial recognition of the expense and corresponding liability throughout the service period
- The reversal once the payment is made
In many cases, accrued expenses represent an estimate of how much an organization expects a bill to be, so the reversal entry is critical to this process.
Step 1: Expense is incurred
When an expense is incurred, a debit is recognized for the accrued expense, and a credit is booked for the same amount to an accrued liability account. This may continue for multiple months, building up an accrued liability over time.
Step 2: Reversal
Once invoiced for the goods/services that have already been received and a payment is made, the accrued liability is debited to clear out the outstanding balance, and a credit is made to cash for the payment for the services.
Accrued expenses examples
Entities can accrue expenses for a number of reasons. As long as there is a benefit being received, an expense should be recorded. Some common examples of accrued expenses are:
- Accrued interest on a loan
- Accrued salaries, wages, and bonuses
- Payroll taxes
- Utilities
- Other taxes
- Usage based cloud services
- Consulting or other project-based services
- Any other purchases/services received without an invoice
As an example, consider the following:
ABC Company pays utilities through Electric Co. and is invoiced quarterly based on usage for the prior 3 months . For simplicity, let’s assume they have agreed to an averaging method, where the cost is the same each day based on an average cost for the year. The typical cost per month for utilities comes to $1,000 per month.
At the end of each month, ABC Company would make the following entry to recognize the accrued expense for the utilities used during that month:
Each month, $1,000 is added to the accrued liability as the journal entry above is repeated. At the end of the quarter, a few days after the quarter ends, ABC Company receives a utilities bill for $3,000.
The entry at that time to reverse out the accrued liability balance is as follows:
Finding missing accrued expenses
Because accrued expenses are not triggered by an invoice but rather by consumption of goods/services, sometimes it can be difficult to estimate, or even find, accruals. For routine and predictable accruals, calculation is often straightforward. However, for more complex expenses, a structured approach to identify and calculate accruals is necessary.
Examples of ways to estimate accruals
Historical data analysis
The most common method involves analyzing past trends. For recurring expenses like utilities, a company can average the costs from prior periods to estimate the current period’s expense. This method is simple but may not be accurate if there are significant changes in usage or pricing.
Analysis of open purchase orders
A systematic review of open purchase orders (POs) at the end of the accounting period should be completed to review POs for which goods or services have been marked as received but for which no vendor invoice has yet been processed. This gap is an indicator that an expense has been incurred and an accrual is necessary.
Vendor confirmations
For significant, non-recurring expenses, such as professional services or project-based costs, direct communication with vendors is crucial. Requesting a summary of unbilled work performed as of the period-end can provide a highly accurate basis for an accrual.
Contractual analysis
For expenses governed by contracts, such as software or maintenance agreements, the terms of the contract will dictate the amount to be accrued.
Project-based accruals
For large-scale projects, accruals can be estimated based on the percentage of project completion. This often involves collaboration between the accounting and project management teams to determine a reasonable estimate of the work performed.
Conservative estimation
In situations of high uncertainty where a precise figure is difficult to ascertain, a company may adopt a conservative approach by slightly overestimating the expense. This helps to ensure that liabilities are not understated, though it may slightly depress current period earnings. A subsequent true-up is required when the actual invoice is received.
Despite the implementation of robust estimation processes, the risk of missing accruals remains a significant concern, as the failure to identify and record these liabilities can lead to overstated profits and understated liabilities, potentially misleading stakeholders and impacting financial ratio analysis.
Summary
It is important for an organization to correctly identify and account for accrued expenses throughout the year based on services received but not yet invoiced. Accrued expenses and their corresponding accrued liability are essentially the opposite of prepaid expenses and their corresponding prepaid asset, with the main difference being the timing of the payment in relation to the usage period. An organization reporting under US GAAP must follow the accrual basis of accounting which uses the matching principle to recognize expenses in the period in which they are incurred, not necessarily when they are paid.
