When a business accounts for expenses that it will pay off at a future date, it might record these liabilities as accrued expenses. However, even though accrued expenses are scheduled to be paid at a later date, they form an essential accounting element in a business's balance sheet, giving a better idea of the overall financial position.
With accrual accounting, companies also get a fair idea of what liabilities to expect at future dates. In this post, you'll learn the concept of accrued expenses and why they're important for your company.
Accrued expenses represent a company's expenses recorded on the balance sheet before they're paid. Accrued expenses are generally recorded during the accounting period in which they're incurred and are often shown as current liabilities on the balance sheet.
As a small business owner, it helps to account for any incurred expenses that have not been invoiced or paid, which accruing expenses can do. This method of accounting is also known as accrual accounting, which records transactions when they occur rather than when money is paid or changes hands. Some of the examples of accrued expenses include:
- Wages, bonuses, and related expenses of employees not yet paid.
- Interest on loans for which no lender invoice has been received.
- Taxes incurred, with no invoice from a government entity received yet.
- Services or goods received, consumed, or sold, for which no supplier invoice has been received.
- Unused vacation or sick days.
- Expenses for utilities will only be billed in the following month.
- Taxes incurred, for which no invoice from a government entity has yet been received.
Here's an example to understand this better. Suppose you contracted with a housekeeping company on April 1 to get your office premises cleaned regularly. At the end of the month, you didn't receive an invoice from the company, and the bill wasn't paid. As a result, you will record the cleaning expense as an accrual to keep an accurate tab of your liabilities.
Accrual accounting is the method of accounting that recognizes revenue when it's earned and expenses as they're incurred but not paid. You can find accrued expenses on your company's balance sheet as short-term or current liabilities. Some companies may also call accrued expenses spontaneous liabilities.
On the other hand, the cash basis of accounting requires you to record expenses the moment you pay them, so you won't have accrued expenses in your balance sheet.
The benefit of cash accounting is that it is simple and shows how much money you have at hand. However, it isn't accurate, as it might show you profit and loss statement template just because you haven't paid your bills. Accrual accounting gives you a more accurate picture of your business performance and finances.
However, it is more complicated as you need to keep a tab on both invoices and payments. You may even end up paying tax on income before getting paid by a customer in some cases.
Here are some other reasons why accrued expenses are essential to monitoring your business health:
- Accrual accounting can help portray a more accurate picture of your company's health, including accounts receivable and accounts payable. Therefore, you get an instant view of the money coming in and the future liabilities.
- Accrual accounting gives a more accurate description of income and debt. Accounting is done in real-time, making it easier to plan and budget for the future. It is also the best way to share financial reports with investors and shareholders to receive funding.
As discussed, accrued expenses or accrued liabilities are payments that a company is obligated to pay in the future for goods and services already received. These types of expenses are entered on the balance sheet and are usually considered current liabilities.
Naturally, when a company's accrued expenses increase, it means the percentage of unpaid bills is rising. Thus, accrual accounting helps in keeping a tab on the debts.
Though similar to accrued expenses, accounts payable represent the cost of goods and services purchased on credit and usually due within 30 days of the invoice date. Accounts payable are considered current liabilities.
The key difference is that while accounts payable refer to the sum of short-term obligations of a company for goods or services bought on credit, accrued expenses are those expenses in which an invoice or bill has not been received.
Here's an example to help you understand the difference better.
It is March 31. You waltz into the office to take the day head-on when suddenly there's a flash and the lights go out. You immediately call maintenance, and they send someone to repair the issue. Power is shortly restored, but the maintenance company has some software upgrade going on and informs you that it will bill you for the repairs in the subsequent month.
To properly account for the repair expense, you will need to accrue it using a journal entry. Also you can know about bad debt expense which are uncollectible accounts expense or doubtful accounts expense
The following month, when you finally receive the bill, you will also have to reverse the accrual and post the expense properly. There's another small problem – without the invoice, you don't know exactly how much you'll be charged. But having used the service before, you estimate it to be $500.
However, on April 1, you must reverse the accrual lest the expenses and liabilities will be overstated when the bill arrives. The reversal would look like this:
Once the bill arrives in the first week of May, you pay it immediately and record the journal entry as follows:
Making these journal entries manually is a tedious task. However, accounting software can help you by reversing the accrual expenses at the beginning of each month. Once that's done, you only need to enter the invoice when it's received to keep your balance sheet accurate and updated.
Now, we will use the same example to understand an accounts payable expense. Here, suppose the maintenance company immediately provided you with an invoice of $500. However, you needn't pay the bill until the following month. Therefore, it is treated as short-term debt and recorded as an accounts payable item or expense in April.
Once you pay the bill at the end of the subsequent month, the journal entry would be:
Accrual accounting is what you will use to record accrued expenses. Sometimes, however, it gets a little complicated to juggle with so many numbers. If you're feeling overwhelmed or accounting is not your thing, Fincent can handle your bookkeeping immaculately, leaving you free to explore your creative pursuits. Get in touch to know more.