Accrued Expense
It is unpaid financial obligations crucial for day-to-day operations
What is an Accrued Expense?
Accrued expenses are those expenses that are liable financial obligations towards another party that are recognized but yet to be paid by the end of the occurred accounting period by the economic entity (company) for indulging in mutually agreed credit-based transactions.
“But why would a business opt for credit instead of making immediate cash payments, thus avoiding potential headaches?” Well, in theory, it is a relief to NOT be in debt, but in reality, it's a whole different story.
Money is essential for the sustenance and growth of an economic entity, crucial for survival in a competitive market. It is quite difficult for businesses to hold adequate money to sustain day-to-day business operations.
Businesses utilize non-cash-based transactions such as credit to sustain day-to-day business operations.
This nature of credit transactions, which runs on trust that the payment will be made in the future, is prevalent worldwide as businesses in any part of the world require some level of credit to sustain. Yes, cash is king, but a king will not always have cash with him.
Considering such practical situations of not being in a liquid state, some perks and benefits come with credit services that can help alleviate the economic burden for companies. Thus, maintaining credit has become a long-term strategy for several companies.
Accounting standard setters such as FASB and IASB incorporate accrual-based expenses into their standards (US GAAP and international IFRS) to govern ethical and efficient ways to deal with accrued transactions and credit transactions as a whole.
Key Takeaways
- Accrued expenses signify unpaid financial obligations crucial for day-to-day operations, recognized at the end of an accounting period.
- Long-term strategic benefits of credit transactions are governed by accounting standards.
- These expenses encompass taxes, interest, and salaries, recorded at their occurrence and posted under current liabilities.
- In comparison to cash-based accounting, which focuses solely on cash flow, accrual-based accounting emphasizes accuracy and suits large companies.
Understanding Accrued Expenses
Accrual expenses are those expenses that are recognized credit transactions but are yet to be paid within an accounting period. In business terms, these expenses are recognized by the company as they had incurred on credit but are yet to be paid for by the year's end.
An accrued expense is an accounting component of the accrual-based double-entry system based upon the accrual accounting principle, which records the economic transactions based on the event, even the ones that are credit in nature.
Since companies worldwide engage in daily credit transactions, the event is recorded at the occurrence date. Accrued expenses are accrued as the compensation (i.e., payment) is yet to be made within an accounting year, completing the overall transaction.
Note
The amount of the credit expenditure stated in the business, and the amount stated in the suppliers can differ since the amount is paid at a later date. This can change the value of the expenditure, especially if the creditor is in a different country (Foreign Exchange Rate).
Therefore, accrued expenses, being obligations for the business to pay but not paid by the year-end, are posted under the current liabilities section of the statement of financial position (i.e., balance sheet).
Now, you might ask, “How is it a current liability when the payment is not paid within an accounting year?” Usually, case scenarios of accrued expenses are short-term in nature (less than a year from occurrence); therefore, accrued expenses belong in the current liabilities.
Whether an invoice has been issued or not, accrued expenses are in many varieties other than the basic credit purchases. Some of the accrued expense varieties are
- Taxes
- Interest on loan payments
- Warrants on received products or services
- Employee salaries, wages, and bonuses
Be aware that accruing expenses are beneficial up to a limit, but exceeding them may strain the relationship with the creditor. Additionally, any unpaid portion of the accrued expenses accumulates over time, increasing the expenses and liabilities.
Comparison Of Accrued Expenses With Other Accounting Elements
For a company, accrued expenses are not the only form of liability it endures over its economic lifespan. There are other accounting elements that aid the business over appropriate circumstances. Below are some common element comparisons:
| Accrued Expenses | Prepaid Expenses | Accounts Payable |
|---|---|---|
| Expenses that are yet to be paid for the occurred credit transaction are known as accrued expenses. | Expenses paid prior (prepaid) to the event of due obligation are known as prepaid expenses. | Accounts Payable is an accounting terminology used for recurring amounts owed by the company to external parties. |
| Recognized in the event of incurring the credit expense. | Recognized at the time of an advance payment for goods/services that are yet to be received. | Recognized in the event of incurring the invoice. |
| Considered to be short-term credit expenditures that a company is bound to pay in the near future, typically within 12 months. | Considered to be short-term current assets, typically within 12 months. | Also considered to be a short-term credit expenditure that a company is bound to pay in the near future, usually within 12 months. |
| Recorded as a liability in the company’s balance sheet since the expense is an obligation the company has to fulfill as it owes to the creditor for the credit transaction that occurred in the past. | Recorded as an asset in the company’s balance sheet, especially when the company expects a future economic benefit in dealing with prepaid expenses. | Recorded as a liability and thereby posted in the company’s Statement of Financial Position (i.e., Balance Sheet). |
Advantages And Disadvantages Of Accrued Expenses
Accrued expenses are based on the accrual basis of accounting and thus have their pros and cons similar to other accounting methods. Below, we explore some of the advantages and disadvantages of an accrued expense recorded on an accrual basis.
Some of the advantages of having accrued expenses are:
- It eases year-end reporting cut-offs and records when the transaction occurs.
- It is easier to strategize and execute due to alignment with the business operations.
- It allows flexibility to consider several future-focused influential factors.
- It allows accuracy, yielding consistent, accurate financial results, thus providing valuable insights.
- It adheres to the external regulatory and financial reporting requirements.
Some of the disadvantages of incurring accrued expenses are:
- It ignores cash flow and cash usage.
- It is complex to record due to the consideration of several other non-cash factors and financial reporting strategies.
- It is both time-consuming and technically demanding.
- It possesses higher chances of errors and material misstatements.
- It is labor intensive.
Note
Cut-off is an accounting concept that ensures the transactions are reported accurately at the right date of occurrence regardless of the accounting year it falls.
Accrued Expenses Example
Verona Inc. is a small-sized clothing manufacturer based in Texas, USA, that specializes in handcrafted clothing lines and expressing fashion using renewed plastics obtained from the ocean.
Even though Veronica Inc. is operating using ethical methods, which is applaudable, the company still needs a factory to operate so its workers can have decent space to handcraft clothes. Therefore, the company has to pay $480 monthly for the rent.
Let us assume Veronica Inc.’s accounting period starts from April 1st to March 31st. The charged rent for the month of March starts from the 1st of March till the end (31st) of March. But the bill is invoiced at the beginning of April.
Since Veronica Inc. follows accrual-based accounting, the company recognizes the due rent and posts an entry in March. But the due payment will now fall in the next accounting year. Therefore, the due amount is accrued and recorded in the accrued expense account.
Veronica Inc. records the rent of $480 at the end of March, even though the accrued rent becomes an obligation to pay in April. Therefore, the accrued rent is considered a liability. Here is how Veronica Inc. would record its accrued expenses.
| Rent A/c Dr | $480 | |
| To Accrued Expense A/c Cr | $480 |
Based on the Modern Rule of Accounting, any increase in liability is credited, whereas any decrease in liability is debited. Therefore, the accrued expense is credited since Veronica Inc.’s liability has increased.
Note
Have you observed that Veronica Inc. records transactions at the time an event takes place rather than when payment is made? This reflects an accrual-based accounting system, where transactions are logged at the time they occur, regardless of when cash changes hands.
In contrast, cash-based accounting records transactions when cash is exchanged. Accrued expenses, being inherently accrual-based, are recorded in the accrued expense account to reflect the occurrence of the event itself.
Accrued Expenses FAQs
Accrued expenses are the expenses that are yet to be paid for the payment the company owes for the occurred credit transaction by the end of an accounting year. These expenses, being an obligation to pay in the future, are deemed a company's liability, current liability to be specific.
Recording a journal entry is simple once the nature of the account and transaction are understood. The accrued expenses are considered a liability since they need to be paid after the end of the accounting period in which the transaction took place. Therefore, an increase in liability is credited.
| Debit the Expenditure account | $$$ | |
| Credit the Accrued Expense account | $$$ |
Accrued expenses or incomes are those liabilities or assets that the company is yet to pay or receive for the occurred event of exchange by the end of an accounting period. However, accounts payables are liabilities that a company incurs for a short-term credit transaction that the company must pay soon for the goods or services received. Another differentiating factor is that the accounts payable are to be paid shortly, whereas the accrued expenses are accumulated and then paid.
Accrued expenses are obligations of a company (liability) for the occurred credit transaction that are yet to be paid by the end of an accounting period. Prepaid expenses are the absolute opposite, as they are those expenses that are paid before they become a future obligation from the transaction (asset).
A cash-based accounting is the discipline of accounting where the recording objectives revolve around cash movement. Accrual-based accounting is the discipline of accounting where the recording objectives revolve around the event occurrence of a transactional exchange.
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