Accrued expenses stem from a promise.
Let’s say you promised to pay your vendor 1000 dollars for their service at the end of their contract. The vendor delivers services over three months, but you haven’t paid them yet.
This is your accrued expense. It’s crucial for understanding a business’s financial health, especially in cash flow management.
What are the accrued expenses?
Accrued expenses occur when a business incurs an expense but delays the payment. Accountants note these unpaid costs as accrued liabilities on the company’s balance sheet until they settle them.
Accrued expenses fall under current liabilities, indicating the business owes money for products or services it has received but has yet to be billed for. After they’re billed, they get categorized as accounts payables. Typical accrued expenses include bills payable charged at the end of a service month but paid later, employee wages for work done, unpaid interest expenses on loans, and outstanding taxes.
These expenses affect a business by increasing what it owes, decreasing its available cash while reducing profits. Delayed payments might incur additional interest charges, raising the debt.
A high volume of accrued expenses makes it hard for a business to pay off its debts on time. It may even lead to severe outcomes like bankruptcy.
Read About: 10 Best Accounts Payable (AP) Software
What are accrued expenses on a balance sheet?
Accrued expenses on a balance sheet are those a company recognizes when they occur, not when they are invoiced or paid. This approach is known as the accrual method of accounting. It enhances the accuracy of a company’s financial statements, such as the balance sheet and income statement.
On the balance sheet, accrued expenses are reported under the liabilities section. For instance, in a balance sheet excerpt, you might see current liabilities, including wages payable, accounts payable, accrued expenses, and taxes payable.
When you account for these expenses, management gets a clearer picture of the company’s total liabilities. It helps them make better financial decisions.
Balance sheet “Liabilities” excerpt:
- Wages payable: $8,000
- Accounts payable: $5,000
- Accrued expenses: $7,000
- Taxes payable: $3,000
Total current liabilities: $23,000
Except for accounts payables, everything is accrued expenses.
What are the types of accrued expenses?
Below are some common types of accrued expenses that companies record.
- Salary and wages payable: are income owed to employees for their work. Salaries are for full-time employees who earn the same amount every payroll period, regardless of hours worked. Business owners pay wage expenses on an hourly basis.
- Interest payable: is the interest on loans a company has accumulated but not yet paid. Companies often accrue interest payable on loans for equipment and startup costs.
- Other expenses: include taxes and utilities that a business incurs before receiving an invoice or making a payment. For instance, a business might owe taxes for a quarter but not pay them until the end of that quarter.
What is an example of an accrued expense?
Here’s a simple example of an accrued expense.
Zoomart, a garment e-tailing company, pays its employees at the start of next month for the work done in the current month. Employees who worked in November get paid in December. On 31st December, if the company only records salaries already paid, it won’t include December’s wages.
To fix this, they make an adjusting entry on December 31, adding the unpaid December salaries to their expenses on the income statement and to salaries payable on the balance sheet.
When the company gets billed for total salaries, it goes into accounts payable, a short-term liability on the balance sheet. When the finance team pays this, it reduces accounts payable and the cash account by the same amount.
Another example, if a technician fixes an office machine for Zoomart and bills them immediately. This bill gets added to accounts payable. But if a special part is ordered for fixing the machine, it becomes an accrued expense on the balance sheet.
Benefits of tracking and measuring accrued expenses
To maintain a healthy cash flow, you need to track and measure accrued expenses consistently
- Makes financial statements accurate: Measuring accrued expenses keeps financial statements consistent and accurate. It makes business operations transparent.
- Manages cash flow better: The accrual basis of accounting provides a clearer picture of a business’s cash flow and liabilities.
- Makes strategic plan: Tracking accrued expenses allows for consistent financial outcomes. It helps companies to plan for recurring transactions in financial reports.
- Reminds to fulfill contractual obligations: Accrued expenses account for contractually due activities, like services to be paid for, even if not yet incurred.
- Helps comply with regulations: For some companies, especially those with Securities and Exchange Commission (SEC) filing requirements, accrued expenses are necessary for financial reporting.
Read About: Cash Flow Statements: A Comprehensive Guide
Challenges of accrued expenses
While it offers several benefits for business, it comes with its fair share of challenges too.
- Makes accounting complicated: Accrual accounting is more complex than simple cash-based accounting. It requires meticulous record-keeping and an understanding of when to recognize expenses.
- Managing cash flow gets tricky: Even though expenses are recorded, the actual cash hasn’t left the company yet. This can lead to a mismatch between what the books show and the actual cash available, making cash flow management tricky.
- Causes an overestimation risk: There’s a risk of overestimating or underestimating expenses, leading to inaccurate financial statements.
- Consumes time: Keeping track of accrued expenses and accurately reporting them can be time-consuming.
- Makes audits complex: Accrued expenses can complicate audits, as auditors need to verify the expenses are recorded correctly and in the right period.
Quick Read: Cash Flow Problems – 4 Best Ways to Solve It
Accrued expenses vs. prepaid expenses
Accrued expenses and prepaid expenses are two different types of accounting treatments for expenses:
Accrued expenses are recognized when they are incurred, not paid. They present themselves as liabilities on the balance sheet. These expenses relate to the current accounting period and impact a company’s financial accuracy.
On the other hand, companies pay prepaid expenses in advance for goods or services to be received in the foreseeable future. It shows payments already made for benefits that the company will receive later. For example, a company pays an insurance premium for the next year in advance.
Accrued expenses vs. accounts payable
Accrued expenses and accounts payable are both liabilities, but they differ in nature: Accrued expenses are incurred but not paid. These may or may not have an associated invoice.
On the other hand, accounts payable (AP) is the total amount a company owes to suppliers or vendors for goods or services it has already received and has been invoiced for. A company records accounts payable when it receives an invoice from the vendor. For example, the company has received A bill for office supplies and needs to pay.
Suggested read: Discretionary Expenses: Definition, Types, and Budgeting
Automating expense tracking for better cash flow management
Accrued expenses are crucial for accurate financial reporting in any business. It helps financial statements reflect their true financial obligations, supporting better financial planning and decision-making.
Although managing accrued expenses can be tricky due to their complexity and impact on cash flow, proper recording helps add transparency to financial operations. You can leverage expense management software like Happay to eliminate complexity and streamline your finance operations.
Contact the Happay team for a personalized demo of its expense management suite and discover how it keeps your expenses in check.
Accrued expenses – FAQs
Accrued expenses differ from other liabilities in several areas. These are often related to goods and services. However, other liabilities can include a broader range of financial obligations like bonds payables or deferred liabilities.
Accrued expenses may not be recorded at the time they’re invoices. However, other liabilities like accounts payable often have an invoice request for payment. Moreover, accrued expenses are often short-term liabilities expected to be paid off within a year. Other liabilities can be either short-term debts or long-term.
Here are some common examples of accrued expenses in business:
1. Salaries and wages. Money owed to employees for work performed but not yet paid, is typically recorded at the end of the accounting period.
2. Utilities. Costs for services like electricity and water used in a month but billed the following month.
3. Taxes. Taxes that are incurred but not yet payable, such as income or property taxes, are due in the next fiscal period.
These examples highlight expenses incurred within a certain reporting period but paid in a subsequent period, reflecting the company’s actual financial obligations.
The accounting treatment ensures expenses are recorded in the period they’re incurred, providing an accurate picture of the company’s financial health. The accounting treatment for accrued expenses involves the following steps:
1. Recognition. When an expense is incurred but not paid, it’s recognized as an accrued expense.
2. Journal entry. The expense account undergoes a debit, and the income statement reflects the same. Simultaneously, the accrued expense account gets credited. It appears as a current liability on the balance sheet.
3. Adjustment. After paying the expense, accountants debit the accrued expense account.
Accrual accounting helps state the present financial position of a company’s financial performance. It gives a comprehensive view of financial health, helping decision-makers to plan and make strategic decisions. It enables you to prove compliance with industry regulatory standards.
On the balance sheet, accrued expenses increase liabilities. They affect the income statement but don’t directly impact the cash flow as the payment occurs at a later date.
Accrued expenses are prevalent in various industries, but they are especially common in:
1. Service industries: Like consulting, legal, accounting, and bookkeeping firms, where services are often provided before payment is received.
2. Manufacturing: Due to ongoing costs like labor, utilities, and interest on loans for equipment, which may be accrued until paid.
3. Construction: Large projects often incur significant costs over time before billing.
4. Healthcare: Hospitals and clinics accrue expenses related to staff salaries, utilities, and medical supplies.
5. Retail and hospitality: These sectors often have accrued expenses such as rent, utilities, and wages.
Yes, there are specific accounting standards for accrued expenses, primarily governed by Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). These standards provide guidelines on recognizing, measuring, and reporting accrued expenses in financial statements. They encourage accountants to record expenses in the accounting term in which they occur.
The reporting requirements for accrued expenses typically include:
1. Balance sheet presentation: Accrued expenses should be listed as current liabilities on the balance sheet if they are expected to be settled within one year.
2. Expense recognition: In the income statement, expenses must be recognized in the period they are incurred, not when paid, adhering to the accrual accounting principle.
3. Disclosure: Detailed disclosure of the nature and amount of accrued expenses may be required, mainly if they are significant.
4. Documentation and audit trails: Proper documentation and audit trails are necessary for verification during audits and compliance with accounting standards.
Businesses can effectively manage and control accrued expenses through regular monitoring, budgeting and forecasting, internal controls, and time reconciliation. It helps maintain financial accuracy and prevents cash flow issues.
To minimize accrued expenses, businesses can adopt several strategies. You can negotiate payment terms, efficiently manage cash payments, control costs, and review vendor contracts.
Technology has significantly impacted the management of accrued expenses. Automation assists the recording and tracking process to save time and reduce errors. Nowadays, you can track accrued expenses in real time through better financial visibility and control. Financial systems integrate with other software like accounting tools, enterprise resource planning (ERP), and customer relationship management software (CRMs) to ensure seamless management. With technology, you get tools to analyze accrued expenses, assisting better financial decision-making and planning. Overall, it helps you comply better with accounting standards.
1. Future trends and developments in accrued expense management will likely include advanced automation to efficiently process accrued expenses.
2. Using artificial intelligence and machine learning for predictive analytics will help teams make more intelligent decisions related to expense management.
3. Cloud-based accounting software are accelerating with more integrated procurement and payroll management, streamlining business operations. In the foreseeable future, we might observe more usage of regulatory technology (RegTech) to ensure compliance with evolving standards and regulations in an automated manner.