Accrued Expense

What are accrued expenses?

Accrued expenses, also known as accrued liabilities, are expenditures recognized on a company’s balance sheet after liability is incurred before payment is made. Recording these expenses on a balance sheet allows companies to gauge their financial statements more accurately and streamline financial management with accounting software. 

Accrued expenses represent future payments and liabilities. They’re recorded as current liabilities on a balance sheet. In certain situations, accrued expenses can be an estimate of a future supply of goods or services. 

How do accrued expenses work?

In a company’s financial book, accrued expenses are recorded as current liabilities to be paid immediately or in the future. 

So, what counts as an accrued expense?

An example of accrued expense is when purchasing goods or services. In this situation,  a company's finance team makes separate entries into a financial management system. In some cases, these entries help estimate expenses until receipt of a final invoice. It’s interesting that companies calculate accrued income regardless of the fact that they haven’t received it yet.

Another example is when an organization uses a cleaning service, but the cleaning company doesn’t invoice until the end of the month, the organization marks this as an accrued expense in its financial books. The costs are accrued until they’re settled, and can be in the form of:

• Salary: Since most companies pay employees in the first few weeks of the month, salaries are recorded as “accruals” in the previous month. 

• Tax: Companies pay taxes toward the end of a fiscal year. Taxes are accrued for twelve months. 

• Interest: If companies have taken out loans, the interest payments accrue until the time of payment. 

Benefits of accrued expenses

Accrued expense offer many benefits, from providing a clear financial picture to high accuracy. Here are some of its benefits: 

• Provides a complete financial picture: The accrual method of accounting provides a complete and accurate picture of a company’s financial transactions. This helps companies understand how profitable they are, where the profits come from, and how the expenses are used. 

• Preferred by stakeholders: Shareholders and investors prefer to view a company’s financial statements using the accrual accounting method. Since accrual reports provide a clearer picture of a company’s income flow, they’re preferred.

• A better method for budgeting: Accrued expenses allow companies to view their business finances in real time. They can better gauge their past financial performance and plan more accurately for the future. 

• It is GAAP-compliant: Generally Accepted Accounting Principles (GAAP) is an industry-standard for financial statements in the US. GAAP permits only accrual accounting. Although GAAP compliance is relevant only to public companies, it benefits smaller businesses by facilitating loan approvals and drawing investors.

Accrued expenses best practices

While accrued accounting is simple, companies can follow some best practices to further simplify the process. 

• Use accounting automation software: Invoice automation software lets companies issue invoices, accrue payments, record expenses, and even handle reporting. Companies can change from cash basis accounting to accrual in just a few clicks. 

• Budget annually: Preparing an annual budget is key to accrued expenses. This can be done by analyzing yearly financial activities. 

• Monitor calendar closely: A company’s calendar should be closely monitored for pending payments, expenses, and more. This ensures that teams stick to deadlines and that payments are made quickly without delays. 

• Forecast budget: When there’s a difference between cash in hand and actual spending, companies should create a budget forecast. This helps them make critical and informed financial decisions. 

• Work with the operations team to verify expenses: Regularly review monthly expenses with the financial team. The financial team is generally aware of transactions potentially gone under the radar.

• Document the entire accounting process: It’s a good practice to document all financial activity promptly. Whether the change is small or a big, undocumented changes can greatly impact a company’s ability to make decisions. This brings all teams involved on the same page and helps avoid potentially big mistakes. 

Accrued expenses vs. accounts payable

Accrued expenses can sometimes be confused with accounts payable.

Accruals are recorded before receiving an invoice, while accounts payable are entered after. Accounts payable requires companies to record the specific amount to be paid. On the other hand, accruals are largely the estimates of what a product or service would cost the company. Also, accrued expenses accumulate over time, while accounts payable doesn’t. 

Accrual vs. cash basis accounting

Like accrual method of recording incurred expenses, there’s another accounting method known as cash basis. In this method, expenses are recorded only during an exchange of money. While more straightforward, the accrual method shows a more accurate measure of a company’s profitability than the cash basis method.

Accrued vs. deferred expenses