Accrued expenses comprise all expenditure that a company by obligation is expected to pay in the future for goods and services already received. This type of expense is recorded as current liabilities in the company’s balance sheet at the end of an accounting period. Accrued expenses are an essential concept in accrual accounting.
Accrued expenses account becomes necessary because businesses have expenses incurred in the past which has to be paid for in the future. These expenses are recognized when the business incurs them and not necessarily when the payment is made. This is in adherence to the accrual accounting matching principle which mandates the reporting of expenditure within the period such expenditure occurred.
Without the business recording accrued expenses in the period they were incurred, the figures on the balance sheet will not be an accurate representation of the financial standing of the business. The profit reported within that period will be very high whereas the business has unpaid financial obligations.
There are several ways a business accumulates expenses. Here are some of the common examples:
- Accrued Interest: The outstanding loan interest a business owes which hasn’t been billed at the end of the accounting period.
- Accrued Goods and Services: You may have received goods or services, but the vendor bills you on a later date from the date the goods or services were received.
- Accrued Payroll Tax: This is when the employment taxes from employee wages are withheld but you still owe them for the next accounting period.
- Accrued Wages: This is when the employee wages are paid in arrears, which is in the following period.
- Accrued Commissions: Your commission payment in a project is delayed till the following period.
- Accrued Utilities: The utilities you have used for your business are yet to be billed.
- Accrued Rents: Your rent payment enters the following month because the previous invoice is yet to be received.
Let’s also take, for example, the situation whereby a company receives its office supplies from their supplier almost at the end of the month, and the invoice from the supplier is yet to be received at the time of closing its book for the month.
For the invoice to be recorded in the month of receipt, the account officer will have to record the expense in the supplies expense account with a debit in that month, stating that it is expected to be billed by the supplier. The officer also goes ahead to record a credit to an accrued expenses liability account.
That is if the office supplies amount to $800, the journal entry will have to show a debit of $800 to the office supplies expense account and a credit of $800 to the accrued expenses liability account. If we are to continue with our example, the $800 will have to be reversed the following month, with a credit to the office supplies expense account and a debit to the accrued expenses liability account.
Once the company receives the supplier invoice for $800, it records it in the normal process through the account payable module of the accounting software.
This then results in the debit of the office supplies expense account and a credit to the accounts payable account. The net result seen the following month will therefore not be a new expense recognition, with the expense for payment moving to the accounts payable account.
If you are set to record an accrued liability you will need to create an accrued expense journal entry using the debits and credits in the accrued journal entry. This means that you make two opposite but equal entries for each transaction. How do you use these for your accrual accounting entries?
Accrued liability works hand in hand with expense and liability accounts. The debit increases the expense account while the credit decreases the expenses account. If done oppositely, you’ll see that a credit increases liability account and a debit decreases liability accounts. Do not forget that accrued liabilities are reversing entries.
They are entries temporarily used to adjust your books between accounting periods. This is how you make your initial journal entry for accrued expenses. The original record is flipped with another entry when you pay the due amount. The two steps for creating an accrued liabilities entry is:
You incur an expense at the end of the accounting period when the debt you owe is yet to be billed. This way you make an accrued liability entry in your book. You already know that an accrued expense journal entry is a debit to an expense account and this debit entry increases your expenses.
If you also apply a credit to an accrued liabilities account, the credit increases your liability. What then happens when you make these entries? Your expenses will increase on the income statement while your liabilities will increase on the balance sheet.
At the next accounting period, you have the expense of reversing the original entry in your books. You then debit the accrued liability account to decrease your liabilities.
The more you offset your debts, the fewer liabilities you have. If you pay the expense with a cash account, you will need to credit the cash account (also known as an asset account). The credit decreases the amount of cash you have.
When the original entry is reversed to show a claim that you paid the expense, you must remove it also from the balance sheet.
Your liabilities decrease, and because you have paid it, your income statement will show a decrease in cash. If the entry adjustment is not done after paying the expenses, you’ll develop some issues in your books.
Here are a few of the issues you might likely encounter:
- On the balance sheet, the liabilities will be understated.
- On the income statement, the expenses will be understated.
- Also, the net income will be overstated.
In the end, your financial report will start showing that you have more money than you do. Each time you pay a liability, be sure to keep your entries up-to-date.
The total salary expense of PACE group of companies for the month of February is $40,000. $5,000 out of this amount has not been paid to the employees. PACE group of companies will recognize $40,000 as the salary expense in the accounting period it was incurred even though the company has not paid $10,000 from this amount.
The journal entry at the end of February will be recorded as shown below:
|Feb, 28||Salary and Wage Expenses||$40,000|
|Cash or Bank||$30,000|
|Salary and Wage Payable||$10,000|
Though the accrued expenses are not paid in the period it occurred, it is recorded on the balance sheet for the period.
This is very important for an accountant as it gives an insight on how to maintain a transparent accounting with the matching principle. If an investor is to see it from their point of view, it will be that the accrued expense shows an accurate picture of the company’s profit.