Accrued Expense: What It Is, With Examples and Pros and Cons

What Is an Accrued Expense?

An accrued expense, also known as accrued liabilities, is an accounting term

that refers to an expense that is recognized on the books before it has been
paid. The expense is recorded in the accounting period in which it is incurred.
Accrual accounting is the generally accepted accounting practice's
(GAAP) preferred accounting method.

Understanding Accrued Expenses

Since accrued expenses represent a company's obligation to make future cash

payments, they are shown on a company's balance sheet as current liabilities.
An accrued expense can be an estimate and differ from the supplier’s invoice
that will arrive at a later date. Following the accrual method of accounting, expenses
are recognized when they are incurred, not necessarily when they are paid.

An example of an accrued expense is when a company purchases supplies from

a vendor but has not yet received an invoice for the purchase. Other forms of
accrued expenses include interest payments on loans, warranties on products or
services received, and taxes—all of which have been incurred or obtained, but
for which no invoices have been received nor payments made. Employee
commissions, wages, and bonuses are accrued in the period they occur
although the actual payment is made in the following period.

Accrual vs. Cash Basis Accounting

Accrual accounting differs from cash basis accounting, which records financial
events and transactions only when cash is exchanged—often resulting in the
overstatement and understatement of income and account balances.
Although the accrual method of accounting is labor-intensive because it requires
extensive journaling, it is a more accurate measure of a company's transactions
and events for each period. This more complete picture helps users of financial
statements to better understand a company's present financial health and
predict its future financial position.

Accrued Expenses vs. Prepaid Expenses

Accrued expenses are the opposite of prepaid expenses. Prepaid expenses are
payments made in advance for goods and services that are expected to be
provided or used in the future. While accrued expenses represent liabilities,
prepaid expenses are recognized as assets on the balance sheet. This is because
the company is expected to receive future economic benefit from the
prepayment.

On the other hand, an accrued expense is an event that has already occurred in
which cash has not been a factor. Not only has the company already received
the benefit, it still needs to remit payment. Therefore, it is literally the opposite
of a prepayment; an accrual is the recognition of something that has already
happened in which cash is yet to be settled.

Advantages and Disadvantages of Accrued Expenses

Advantages
Accrued expenses theoretically make a company’s financial statements more
accurate. While the cash method is more simple, accrued expenses strive to
include activities that may not have fully been incurred but will still happen. Consider
an example where a company enters into a contract to incur consulting services.
If the company receives an invoice for $5,000, accounting theory states the
company should technically recognize this transaction because it is
contractually obligated to pay for the service.
Accrued expenses also may make it easier for companies to plan and strategize.
Accrued expenses often yield more consistent financial results as companies can
include recurring transactions in their financial reports that may not yet have
been paid. In addition, accrued expenses may be a financial reporting
requirement depending on the company and its Securities and Exchange
Commission filing requirements.

Disadvantages
Because of additional work of accruing expenses, this method of accounting is
more time-consuming and demanding for staff to prepare. There is a greater
chance of misstatements, especially is auto-reversing journal entries are not
used. In addition, a company runs of the risk of accidently accruing an expense
that they may have already paid.

Last, the accrual method of accounting blurs cash flow and cash usage as it
includes non-cash transactions that have not yet impacted bank accounts. For a
large company, the general ledger will be flooded with transactions that report
items that have had no bearing on the company's bank statement nor impact to
the current amount of cash on hand.

Accrued Expenses
Pros

 Potentially makes financial more aligned to actual business operations

 Often makes month-over-month financial statements more consistent
 May yield ore useful information for management to make decisions/plans
 Adheres to external financial reporting requirements

Cons

 Often requires more time and resources to prepare compared to the cash
method of accounting
 Usually results in greater risk of misstatement (accruals not reversing or
accidental duplication)
  May complicate some reporting by blurring cash usage and capital needs

Special Considerations

Reversing Entries
A critical component to accrued expenses is reversing entries, journal entries
that back out a transaction in a subsequent period.

Accrued expenses are not meant to be permanent; they are meant to be

temporary records that take the place of a true transaction in the short-term.
Every accrued expense must have a reversing entry; without the reversing entry,
a company risks duplicating transactions by recording both the actual invoice
when it gets paid as well as the accrued expense.

Many accounting software systems can auto-generate reversing entries when

prompted.

Month-End/Year-End
Accrued expenses are prevalent during the end of an accounting period. A
company often attempts to book as many actual invoices it can during an
accounting period before closing its accounts payable ledger. Then, supporting
accounting staff analyze what transactions/invoices might not have been
recorded by the AP team and book accrued expenses.

For companies that are responsible for external reporting, accrued expenses
play a big part in wrapping up month-end, quarter-end, or fiscal year-
end processes. A company usually does not book accrued expenses during the
month; instead, accrued expenses are booked during the close period.

Example of Accrued Expense

A company pays its employees' salaries on the first day of the following month
for services received in the prior month. So, employees that worked all of
November will be paid in December. If on Dec. 31, the company’s income
statement recognizes only the salary payments that have been made, the
accrued expenses from the employees’ services for December will be omitted.

Because the company actually incurred 12 months’ worth of salary expenses, an

adjusting journal entry is recorded at the end of the accounting period for the
last month’s expense. The adjusting entry will be dated Dec. 31 and will have a
debit to the salary expenses account on the income statement and a credit to
the salaries payable account on the balance sheet.

When the company’s accounting department receives the bill for the total
amount of salaries due, the accounts payable account is credited. Accounts payable
is found in the current liabilities section of the balance sheet and represents the
short-term liabilities of a company. After the debt has been paid off, the
accounts payable account is debited and the cash account is credited.

How Are Accrued Expenses Accounted for?

An accrued expense, also known as an accrued liability, is an accounting term

that refers to an expense that is recognized on the books before it is paid. The expense
is recorded in the accounting period in which it is incurred. Since accrued
expenses represent a company's obligation to make future cash payments, they
are shown on a company's balance sheet as current liabilities.

What Are Some Examples of Accrued Expenses?

An example of an accrued expense is when a company purchases supplies from

a vendor but has not yet received an invoice for the purchase. Other forms of
accrued expenses include interest payments on loans, warranties on products or
services received, and taxes—all of which have been incurred or obtained, but
for which no invoices have been received nor payments made. Employee
commissions, wages, and bonuses are accrued in the period they occur
although the actual payment is made in the following period.
How Does Accrual Accounting Differ From Cash Basis Accounting?

Accrual accounting measures a company's performance and position by

recognizing economic events regardless of when cash transactions occur,
whereas cash accounting only records transactions when payment occurs.
Accrual accounting presents a more accurate measure of a company's
transactions and events for each period. Cash basis accounting often results in
the overstatement and understatement of income and account balances.

What Is a Prepaid Expense?

A prepaid expense is a type of asset on the balance sheet that results from a
business making advanced payments for goods or services to be received in the
future. Prepaid expenses are initially recorded as assets, but their value is
expensed over time onto the income statement. Unlike conventional expenses,
the business will receive something of value from the prepaid expense over the
course of several accounting periods.

What Is the Journal Entry for Accrued Expenses?

Accrued expenses are recognized by debiting the appropriate expense account

and crediting an accrued liability account. A second journal entry must then be
prepared in the following period to reverse the entry.

For example, a company wants to accrue a $10,000 utility invoice to have the
expense hit in June. The company’s June journal entry will be a debit to Utility
Expense and a credit to Accrued Payables. On July 1st, the company will reverse
this entry (debit to Accrued Payables, credit to Utility Expense). Then, the
company theoretically pays the invoice in July, the entry (debit to Utility
Expense, credit to cash) will offset the two entries to Utility Expense in July.

The Bottom Line

Companies using the accrual method of accounting recognize accrued expenses,
costs that have not yet been paid for but have already been incurred. Accrued
expenses make a set of financial statements more consistent by recording
charges in specific periods, though it takes more resources to perform this type
of accounting. While the cash method of accounting recognizes items when they
are paid, the accrual method recognizes accrued expenses based on when
service is performed or received.