Accrued expenses are expenses incurred that have not yet been paid. To ensure that period-ending reporting is accurate, accrued expenses need to be recorded prior to running financial statements.
In order to accrue expenses, you must be using the accrual method of accounting, which records revenue and expenses when they occur. Both the matching principle and the expense recognition principle are core components of the accrual method of accounting.
Overview: What is an accrued expense?
As a small business owner, you need to account for any incurred expenses that have not yet been invoiced or paid, and you do this by accruing expenses. To better understand accrued expenses, it may be helpful to become familiar with the following accounting terms:
- Accounting period: A specific period of time that is covered by financial statements. An accounting period can be one month, a quarter, or one year, depending on your business.
- Accounts payable: Accounts payable is the money you owe vendors and suppliers for goods and services purchased on credit.
- Accrual accounting: Accrual accounting records transactions when they occur, rather than when money changes hands.
- Expenses: Expenses are the cost of doing business and are necessary in order to earn revenue.
- Financial statements: Financial statements report on the financial performance of your business and are used internally and externally. There are three basic financial statements that should be run after each accounting period: balance sheet, income statement (profit & loss statement), and cash flow statement.
- Journal entry: Journal entries record the financial transactions of your business into the general ledger.
Here are a few expenses that should be accrued at the end of an accounting period:
- Wages and related expenses for employees who have not yet been paid
- Sales commissions earned in the current month that will not be paid until the following month
- Taxes incurred
- Services received prior to receiving an invoice from the vendor
- Goods received prior to receiving an invoice from the supplier
- Interest payments on loans
Your accrual should always reflect the amount due when possible. If you don’t have an exact total, you’ll need to estimate the expense.
As an example, on May 1, you contract with a cleaning company to clean your office four times a month. As of May 31, you have not received an invoice from the company for the office cleaning, nor has the bill been paid. To account for that expense properly, you will need to record the office cleaning expense as an accrual.
Accrued expenses vs. accounts payable: What's the difference?
Managing expenses for your business is done in one of two ways: through accounts payable or by recording accrued expenses. Accrued expenses are expenses that are owed for goods or services that have already been received, but have not yet been entered as expenses in your ledger or your accounting software.
Accounts payable, though similar, represent the cost of goods and services that you have purchased on credit and are usually due within 30 days of the invoice date. Accounts payable are considered current liabilities.
Take a look at the following example of when you should accrue an expense.
It’s the last day of April, and Carol’s computer crashes. A computer repair service arrives and fixes Carol’s computer, telling her that he will bill her the following week. In order to properly account for the computer repair expense, Carol will need to accrue it using a journal entry.
When she receives the bill next month, she will need to reverse the accrual and post the expense properly.
Carol does not know exactly how much the bill will be, but she has used the repair service before, so she estimates how much to accrue based on prior bills.
The above entry will be reversed as of May 1. If an accrual is not reversed, both expenses and liabilities will be overstated once the bill arrives and is recorded. The reversal would be:
Once Carol receives the bill, she pays it immediately, recording the journal entry as follows:
One of the benefits of using accounting software is that most accounting software applications will automatically reverse accrued expenses at the beginning of the new accounting period. With the accrued entry reversed, all you’ll need to do is enter the invoice when it’s received.
Next is an example of an accounts payable expense.
It’s the last day of April, and Carol’s computer crashes. A computer repair service arrives and fixes Carol’s computer, leaving her with an invoice in the amount of $350. Carol enters the invoice as an accounts payable item, which records the expense in April, even though the bill will not be paid until the following month.
Once Carol pays the bill, the journal entry would be:
How do you record accrued expenses?
To record accrued expenses, you must be using the accrual method of accounting. If you’re using the cash method of accounting, there is no need to accrue expenses since you only record income and expenses when money changes hands.
Accrued expenses are typically entered at the end of an accounting period and are usually part of your adjusting entries.
Here is another example of an accrued expense.
It’s May 31, and you realize you have not received a utility bill for the month. If you don’t account for that expense, your May utility expenses will be understated, while June’s utility expense will be overstated.
In order to be sure that the expense is recorded for the proper month, you accrue it. You don’t know how much the bill will be, but you can make an educated guess by reviewing past bills.
Based on last year’s bills, you estimate that this bill will be $650.
At the beginning of the next accounting period, the above entry will be reversed:
Your utility bill finally arrives on June 1, in the amount of $710, and will be recorded in accounts payable.
|6-01-2020||Utility Expenses||$ 710|
Finally, when the bill is paid on June 10, you will record one last journal entry:
While the accrual of $650 for the utility expense was close to the final bill of $710, an additional $60 of utility expense will be recognized in the month of June that was not expensed in May. You’ll complete this same process when recording accrued wages or salaries payable for employees.
Accruing expenses means more accurate accounting
Using the accrual method of accounting provides you with the opportunity to present a more accurate picture of your business and its financial health.
When you record accrued expenses, you are directly impacting net income totals and, subsequently, retained earnings, and owners’ equity. If expenses are not accrued, expenses will be too low in one month, and too high in the following month.
One of the best tools for managing accruals is accounting software, which can simplify the entire accrual process, from consolidating journal entries to automatically reversing accruals. If you’re in the market for accounting software for your business, be sure to check out The Blueprint’s accounting software reviews.