When a business or organization accounts for expenses that it will pay off at future dates, the company might record these liabilities as accrued expenses. Even though accrued expenses are scheduled for a future payoff, they are an important accounting element included in a business’s balance sheet that can allow the business to better understand its financial position.
Additionally, accrued expenses may also allow a business to get a better idea of what liabilities to expect at future dates. In this article, you will learn what accrued expenses refer to, the main types of accrued expenses and how accrued expenses are used to accurately reflect a company’s financial status.
Here’s what we’ll cover in this article:
- What is an Accrued Expense?
- Types of Accrued Expense
- How is an Accrued Expense Recorded?
- Prepaid Expenses vs. Accrued Expenses
What is an Accrued Expense?
Accrued expenses are costs that are incurred in the current period but not paid for until the next period. In other words, it’s an expense that the company has benefited from but hasn’t paid for or recorded yet. This is why an accrual is recorded as a liability at the end of a period. It’s the number of expenses owed to another company.
Types of Accrued Expenses
There are several types of accrued expenses that a company may record in its financial statements. Payable wages, interest and other expenses like loan interest or taxes can all be considered accrued expenses.
Payable wages or salaries
The payable wages or salaries of a company refers to the income that employees are paid for their work. The payable salary period may follow a weekly, bi-weekly, monthly or bi-monthly schedule. Oftentimes, an organization’s pay period may end before the accounting period, meaning an organization must account for the future pay in the current accounting period. So when a company tracks expenses in their financial records, the salary that is expected to be paid to the employee after the accounting period should be recorded as an accrued expense.
Interest payable refers to any interest expenses (like interest on a loan) that a company has incurred but has not yet paid off. An entry in a company’s financial books would need to be adjusted in the future to reflect the change in this type of accrued expense.
Other expenses—like office rent, utilities or taxes—that have not yet been paid by a business are also considered accrued expenses, since a business has collected liabilities that it has to pay off into the future.
How is an Accrued Expense Recorded?
The following examples show how to record an accrued expense under different circumstances:
- Office supplies received and there is no supplier invoice as of month-end: Debit to office supplies expense, credit to accrued expenses.
- Employee hours worked but not paid as of month-end: Debit to wages expense, credit to accrued expenses.
- Benefit liability incurred and there is no supplier invoice as of month-end: Debit to employee benefits expense, credit to accrued expenses.
- Income taxes are accrued based on income earned. Debt to income tax expense, credit to accrued expenses.
The first three entries should be reversed in the following month. Income taxes are typically retained as accrued expenses until paid, which may be at the end of a quarter or year.
The following examples illustrate how accrued expenses can be listed within a company’s financial record books, as well as how both accrual accounting and cash basis accounting can be applied when recording accrued expenses.
Example of an accrued expense listed as a current liability
Geo Space Contractors, a contracting firm that operates from a large office space, has to update its electrical system to meet current regulations. The company hired an electrician to complete the job on June 28. However, the electrician will finalize and send the invoice to Geo Space Contractors on July 10 in the amount of $12,500.
Because the invoice will be sent after the current accounting period, the company may need to accrue the expense and related current liability in its financial books before the period ends. This liability may be recorded as a repair expense or a credit to “accrued expenses payable” in the amount of $12,500. The accrued expense may then be adjusted when the company receives the actual invoice, and it could reflect a value lower or higher than the estimated expense.
Example of an accrued expense listed as a current asset
Geo Space Contractors has an earned interest on its investment in U.S. treasury bills for an amount of $6,500. The interest earned is reflected in the company’s records on January 30. However, the company expects to receive its interest funds in April.
Since the company needs to prepare its quarterly financial statements, it might accrue the interest earned and reflect that as a current asset before it finalizes its quarterly financial statements. Geo Space Contractors would then adjust the entries for its debit to “interest receivable” to credit to its “investment income” accounts in the amount of $6,500.
Example of accrued expenses recorded using accrual accounting
Let’s assume a corporate law firm has $125,000 balance in accrued expenses in the form of wages and mortgage payments. Because the firm expects to make payment on these expenses into the future, the accountant for the firm may choose to itemize these expenses within the firm’s financial books. Even though these accrued expenses have not been paid yet, they will still account for the company’s expenses when calculating profit and revenue. The firm’s accountant may also adjust the amount of $125,000 into the firm’s future monthly expenses to reflect how the accrued expenses are broken down.
Once payments have been made, the accountant may also adjust the amounts to reflect actual payments made against the firm’s accrued expenses.
Example of accrued expenses recorded using cash accounting
The same corporate law firm that accrues $125,000 in expenses might also use cash accounting to track actual transactions resulting in payments made. The firm’s accountant may record each transaction as actual payments made, which can reflect a different amount than the initial expense of $125,000 since the accountant is only keeping track of transactions where money exchanges are made, rather than estimated future payments. The result may show the firm’s expenses as less than $125,000 because of payments made, and may not make future payments into consideration when the accountant is preparing the law firm’s financial statements.
Prepaid Expenses vs. Accrued Expenses
A prepaid expense is the reverse of an accrued expense since liability is being paid before the underlying service or asset has been consumed. Consequently, a prepaid asset initially appears on the balance sheet as an asset. It is typically presented as a short-term asset since most prepaid expenses will be consumed within a short period of time.