What Is an Accrued Expense in Accounting?
Discover how accrued expenses ensure your financial statements accurately reflect incurred costs, even before payment.
Accrued expenses are a fundamental accounting concept that provides a precise view of a business’s financial position. They ensure financial reports align economic events with the periods in which they occur, supporting better financial analysis.
Understanding Accrued Expenses
An accrued expense is a cost that a business has incurred but has not yet paid or received an invoice for. These represent financial obligations for goods or services already received or consumed, creating a liability even before a bill arrives or cash changes hands. Companies recognize these expenses to accurately reflect the true cost of operations within a specific accounting period.
Accrual basis accounting, the preferred method under Generally Accepted Accounting Principles (GAAP), dictates that revenues are recognized when earned and expenses when incurred, regardless of when cash is exchanged. The matching principle requires expenses to be recorded in the same period as the revenues they helped generate. For costs not tied to revenue, the expense is recognized when used or expired. Adhering to these principles offers a consistent and realistic picture of profitability.
Common Accrued Expense Examples
Accrued salaries and wages are a frequent example, as employees earn their pay throughout a period, but payment often occurs in the subsequent period. For instance, if a company’s payroll period ends on December 31st, but paychecks are issued on January 5th, the wages earned in December are an accrued expense for December.
Accrued interest on loans is an accrued expense. Interest accumulates daily on outstanding debt, even if payments are only due monthly or quarterly. The portion of interest incurred but not yet paid by the end of an accounting period is recognized as an accrued expense. Utility services, such as electricity or water, are consumed continuously, but invoices are received and paid weeks after usage. The cost of utilities used up to the end of an accounting period, for which no bill has been received, is an accrued expense. Accrued rent also occurs when a business occupies a space before the rent payment is due, recognizing the expense for the period of occupancy.
Accounting for Accrued Expenses
An adjusting journal entry is made at the end of an accounting period to recognize the expense and the corresponding liability. This entry involves debiting the relevant expense account, which increases the expense on the income statement, and crediting an accrued liability account, such as “Accrued Wages Payable” or “Accrued Interest Payable,” which increases a current liability on the balance sheet. For example, accrued payroll would debit “Wages Expense” and credit “Accrued Wages Payable.”
Accrued expenses are classified as current liabilities on the balance sheet, as they represent obligations expected to be settled within one year. On the income statement, these expenses impact the reported net income for the period in which they were incurred, even if cash has not yet been disbursed. To prevent double-counting the expense when the actual invoice is received and paid, some companies use a reversing entry at the beginning of the next accounting period. This reversing entry effectively cancels the accrued liability, and the subsequent payment of the invoice clears the cash account.
Accrued Expenses vs. Other Financial Items
The key difference between accrued expenses and accounts payable lies in the timing of documentation. Accrued expenses are costs incurred for which no invoice has yet been received, meaning the exact amount might be an estimate. Accounts payable, conversely, are obligations for which an invoice has already been received, confirming the exact amount owed to a vendor or supplier. Both are classified as current liabilities on the balance sheet.
Prepaid expenses represent the opposite situation from accrued expenses. With prepaid expenses, a company pays cash in advance for goods or services it will receive or consume in a future period. Examples include paying for a year of insurance upfront or subscriptions. These upfront payments are initially recorded as assets on the balance sheet and are only recognized as expenses on the income statement as the benefit is used over time. Accrued expenses involve receiving the benefit before paying, whereas prepaid expenses involve paying before receiving the benefit.