Accrued expense or accrued liabilities is the term describing the payments or expenses that the company incurs or recognizes but would be due for the payment in the future. ‘Accrued’ means to increase or accumulate. So, when a company accrues expenses, its unpaid bills are increasing.
Under the accrual method of accounting, a company needs to recognize expenses as and when it incurs them and not when it pays for them. A good example of such an expense is the company has got the supplies but is yet to get the invoice for the same.
An accounting manager needs to pair such expenses against revenue via GAAP’s matching principle. As per the matching principle, a company needs to record expenses in the period they occur.
These expenses are liabilities as the company needs to settle them in due time. Therefore, accounting managers record them as a current liability side on the Balance Sheet.
An accounting manager makes sure that they record all accrued expenses in the book at the end of every accounting period. These adjustments are necessary to show the goods and services that a company has availed of but not yet paid for. To account for such expenses, the accounting manager needs to come up with an adjusting entry.
Take, for instance; the company pays salary to its employees on the 1st of every month for their service throughout the last month. So on December 31st, if the company’s income statement takes into account only the salary paid, then the accounting manager must not consider the accrued salary expense for December.
However, the company needs to recognize 12 months of salary. Thus, the company passes an adjusting journal entry to accrue the last month’s expense. This entry will debit the salary account on the income statement and credit the salaries payable account on the balance sheet.
Now, when an accounting manager receives a bill for the salaries due, it credits the accounts payable account. After the company pays the debt, the company debits the accounts payable account and credits the cash account.
Types of Accrued Expenses
There are various types of accrued expenses, but two significant ones are:
Accrued Salary and Wages
Accrued wages and salaries are a regular thing in a company. However, unlike a salary, which a company usually pays on a monthly basis, wages can be hourly or weekly. A company paying wages to the workers would include accrued wages in the current liability. Just like other accrued items, recording accrued wages helps the company to keep track of what it needs to pay.
Another commonly found accrued expense in the books of a company is notes payable or accrued interest. Notes payable are the promissory notes issued by banks, organizations, or individuals. These notes act as an obligation for the issuing entity to pay back the amount by the due date. On the other hand, accrued interest is interest on a loan from a bank or any other financial institution.
Let’s understand this with the help of an example. Assume Company A has a loan of $100000 @ 1% per month, and its accounting year ends on 31st March. Company A pays the interest for March 2019 on 5th April.
As per the matching concept, even though Company A pays the interest for March in April, it will record an interest expense of $1,000 in its financial statement for the year ending 31st March 2019. The Journal entry will be Interest Expense account debut and Interest Payable account credit. When Company A makes the payment on 5th April, the journal entry will get reverse, i.e., debit interest payable and credit bank or cash.
Advantage of Accrued Expense Journal entry
Journal entry for accrued expenses comes into play when there is no expense documentation. In such a case, a journal entry is made to recognize the accrued expense in the income statement. Also, an adjusting entry is made to record the expense as a current liability on the balance sheet.
- One of the many advantages of recording accrued expenses is to identify the true profit of the company. If a company does not add the expense that it needs to pay somewhere in the future, the profit might inflate. It is important for all the stakeholders and the company to know the real profit rather than the inflated one.
- All financial transactions, whether accrued or paid, get a journal entry. This leaves zero chance of any error and omission of crucial details. Further, the auditors can also cross-check the books anytime. Regular entry ensures the credibility of the company in the eyes of the auditors and stakeholders.
- Accrued expense entry is based on the double-entry system, which means that debit in one account and credit in the other account. An account manager or anyone looking at the books can see the accounts that such an expense affects. It simply increases the efficiency of the bookkeeping system.
- GAAP recognizes the double-entry system, and thus, several companies follow it around the globe. Therefore, using such a system make the company compliant with international standards.
Disadvantage of Accrued Expense Entry System
- Recording an expense that a company has recognized but did not pay for is a challenging job. Moreover, a slight mistake by the accounting manager could lead to big errors, inflating the profit or even reducing it wrongly.
- Recording accrued expense gets difficult on a daily basis if the size of the business is huge, leading to hundreds and thousands of financial transactions on a daily basis.
Impact on Income Statement
On the other hand, if there is a decrease in accrued expense or a company pays its outstanding accounts payable, the company will credit the cash and debit accounts payable to lower the accounts payable on the liability side. A point to note is that this won’t affect the income statement as cash is not an expense. Also, the expense that the company is paying now has already come in the previous accounting period.
Accrued Expenses vs. Accounts Payable
An accrued expense is the costs that have no invoice. On the other hand, accounts payable are the expenses for which the company has the invoice. Also, the accrued expense is an estimate, and it may differ from the supplier’s invoice.
In contrast, prepaid expenses are the opposite of accrued expenses. Under prepaid expense, a company pays a liability in advance, and thus, it creates an asset on the balance sheet.