What Is an Accrued Expense?
An accrued expense, in accounting, is an expense that is recognized on the books before it has been paid. Because accrued expenses represent a company's obligation to make future cash payments, they are shown on a company's balance sheet as current liabilities; accrued expenses are also known as accrued liabilities. An accrued expense is only an estimate, and likely will differ from the supplier’s invoice scheduled to arrive at a later date.
Following the accrual method of accounting, expenses are recognized when they are incurred, not necessarily when they are paid. Unless an expense is substantial, it is generally not accrued because accrual accounting requires the work of multiple journal entries.
Understanding Accrued Expense
An example of accrued expense is when a company purchase supplies from one of its vendors 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.
When a company accrues (accumulates) expenses, its portion of unpaid bills also accumulates.
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 up in the future. While accrued expenses represent liabilities, prepaid expenses are recognized as assets on the balance sheet.
Accrued Expense in Action
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 December 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 December 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.
- Accrued expenses are recognized on the books when they are incurred, not when they are paid.
- Accrual accounting provides a more accurate financial picture than cash basis accounting.
Why Would a Company Use Accrual Accounting?
Although the accrual method of accounting is labor-intensive because of all of the journaling involved, it also offers a more accurate measure of a company's transactions and events for each period. This more complete picture helps users of financial statements to understand a company's present financial health and predict its future financial position better.
Accrual accounting differs from cash basis accounting, which records financial events and transactions only when cash is exchanged—often resulting in overstatements and understatements of income and account balances.