What is an Accrued Expense?
An accrued expense is a cost that a company incurs in the current period but will pay for in the future.
🤔 Understanding accrued expenses
An accrued expense is money a company spends in the current period but doesn’t pay for until later. In accrual-based accounting, the company records the accrued expense as a liability — a financial obligation to someone else — in the period that the spending took place, even though the company hasn’t paid for it yet. The idea behind accrual accounting is that revenue and expenses should be tracked in the same period that the business activity that generated them occurred — regardless of whether money has changed hands yet. Examples of accrued expenses include accrued utilities (unpaid utilities you owe) and accrued taxes (unpaid taxes you owe).
Let’s review Facebook’s accrued expenses on its balance sheet for the quarter that ended March 31, 2020. In that period, the company reported more than $12.4B in accrued expenses and other short-term financial obligations. This included a $5B penalty as part of Facebook’s settlement with the Federal Trade Commission over violations of user privacy.
(Source: Facebook Quarterly Report, March 2020)
Accrued expenses are like a tab at your neighborhood store…
Some neighborhood stores allow local residents to buy goods on credit. The cashier keeps track of your purchases and asks you to settle the bill at a later date. Likewise, businesses can track accrued expenses when they happen, even though they pay for them later.
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What is an accrued expense?
Accrued expenses, also known as accrued liabilities, are costs a company records in one accounting period (usually a month) and pays for later. Companies track this type of expense using accrual accounting — recording business transactions as they're incurred, instead of when they're paid for. If companies paid for all of their expenses as soon as they incurred them, there would be no need for accrual accounting. Since that’s not the case, recording accrued expenses can give a more accurate picture of a company’s financial state than other methods.
What expenses are accrued expenses?
Any expense that isn’t paid for by the end of the accounting period accrues.
For example, a company that pays employees every two weeks will run into situations in which one month’s wages will be paid in the following month. To account for the wages owed, the company records the expense and establishes a liability. Once the company pays the amount owed, it reduces the liability accordingly.
Other examples of expenses that accrue include payments for interest on loans, utilities not yet paid, rent not yet paid, and legal settlements that haven’t been finalized.
An accrued expense may or may not be an operating expense — a necessary cost for a company’s daily operations that isn’t directly linked to producing a good or service. For instance, rent from a prior month that is paid in the future is both an accrued expense and an operating expense. But a legal settlement that a court orders a company to pay by a specific date is an accrued expense but not an operating expense.
How do you record accrued expenses?
You need to record transactions involving accrued expenses in the general ledger — the company's master record of financial transactions — and on the company’s three financial statements: the balance sheet, income statement, and statement of cash flows.
One of the principal concepts of accounting is the concept of double-entry accounting, which requires two entries that offset each other. Think of it like a seesaw of debits and credits that must stay balanced at all times.
You keep track of accrued expenses by making two entries on the general ledger: one debit journal entry to show the expense and one credit journal entry to report the accrued expense as a liability.
Let’s assume you hire a part-time administrative assistant for one month that charges you $1,500 (including taxes) and sends you the bill on the first day of the next month.
The admin starts working in January, you get the first bill in February, and you pay it in March.
Let’s record the January wage expense on the day that you receive the bill by creating a wage expense account and an accrued liability account for those wages.
Date Account Name Debit Credit Feb. 1 Wage expense $1,500 Accrued liability - wages $1,500
This is the effect of the accrued expense on your company’s balance sheet and income statement by the end of February. At this point, the accrued expense has no impact on the cash flow statement, because you won’t pay the bill until next month.
Balance Sheet for the Month Ended 2/29/2020
Assets Cash $5,000 Other Assets $10,000 Total Assets $15,000
Liabilities Current liabilitiesAccrued liability - wages $1,500 Other Current Liabilities $500 Non-Current Liabilities $2,000 Total Liabilities $4,000
Owners Equity $11,000
Since you’re planning to pay the wage next month, the accrued wage expense is a current liability — a debt that must be paid within 12 months.
Here’s the effect of the accrued expense on the income statement:
Income Statement for the Month Ended 2/29/2020
Revenue $5,000 Total Revenue $5,000
Wage Expense $1,500 Other Expense $500 Total Expenses $2,000
Net Income $3,000
Now, on March 1, you pay the invoice for the owed wages from February for $1,500 with cash.
Date Account Name Debit Credit Mar. 1 Accrued liability - wages $1,500 Cash $1,500
Balance Sheet for the Month Ended 3/31/2020
Assets Cash $6,500 ($5,000 from Jan. + $3,000 Feb. net income - $1,500) Other Assets $10,000 Total Assets $16,500
Liabilities Current liabilitiesAccrued liability - wages $0 Other Current Liabilities $500 Non-Current Liabilities $2,000 Total Liabilities $2,500
Owners Equity $14,000
Since you already recorded the wage expense back in February, the accrued expense doesn’t affect your income statement for March. However, the accrued expense affects your statement of cash flows for March.
Statement of Cash Flows for the Month Ended 3/31/2020
Cash Received from customers $5,000 Cash paid for wages ($1,500)
Cash as of 3/31/2020 $3,500
Are accrued expenses debits or credits?
Accrued expenses can be debits or credits, depending on the type of transaction you’re recording.
An accrued expense is a credit when you first incur the expense and plan to pay for it in a future accounting period.
If you receive a $1,000 bill for local taxes and don’t intend to pay until next month, this is what the transaction would look like on your ledger:
|Accrued liability - taxes||$1,000|
An accrued expense is a debit when you pay part or all of it. Using the previous example, let’s imagine that you pay the entire tax bill with cash:
|Accrued liability - taxes||$1,000|
What is the difference between accrued expenses and accounts payable?
Accrued expenses and accounts payable are two different types of liabilities. They are similar in that both refer to transactions you make now but pay for later. Accounts payable usually refers to inventory or services you receive and is listed separately from other accrued expenses on the balance sheet.
For instance, a company can consider a $900 power drill to be a fixed asset — an asset that would take 12 months or longer to turn into cash. That company would list the drill on its balance sheet as a fixed asset. When buying the drill on credit, the company would create an account payable for the debt, since it doesn’t classify the drill as an expense.
Another firm may consider the drill to be an operating expense and would create an accrued expense when buying the drill on credit.
How is accrual accounting different from cash basis accounting?
Accrual accounting and cash basis accounting differ in terms of when each method records revenue and expenses. Cash basis accounting documents income when it arrives and expenses as you pay them. Accrual accounting, on the other hand, records income when you earn it and expenses when you’re billed, regardless of when cash changes hands.
Cash accounting can be simpler, but bookkeeping using the accrual method can give you a more accurate picture of a company’s financial situation.
If a business only records expenses when cash comes and goes, that can be misleading. The company could appear to have vast cash reserves if it records income from sales, but not payments it owes for expenses incurred in the same period. Many transactions, such as buying supplies on credit, take place before companies hand over cash, and accrual accounting captures all of them.
The Generally Accepted Accounting Principles — guidelines that many organizations follow to keep their books — require accrual accounting.
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