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8 Min. Read

What is Accrued Expense? Importance, Pros & Cons

What is Accrued Expense

Most business owners have previously examined their company’s financial accounts. And in doing so, you would have noticed an item in your books called “accrued expenses” listed as a liability. 

But how can a cost be a liability? Also, is it undesirable that you have accumulated costs? And how are they paid for?

Read on as we take a closer look at accrued expenses, why they’re important, and the advantages and disadvantages that come with them.

Table of Contents

What Is Accrued Expense?

Why Are Accrued Expenses Important?

Advantages of Accrued Expenses

Disadvantages of Accrued Expenses

Accrued Expense vs. Accounts Payable

Accrued Expenses vs. Prepaid Expenses

Example of Accrued Expense

Key Takeaways

Frequently Asked Questions

What Is Accrued Expense?

An accrued expense is a phrase used in accounting to describe an expense recorded in the books that isn’t reimbursed yet. You use the accounting period in which you incur the expense to record it.

On a company’s balance sheet, accrued expenses pop up as current liabilities. This is because they signify a business’s promise to make upcoming cash payments. An estimated cost can actually be slightly different from the invoice of the supplier, which will show up later. 

When expenses are actually incurred, we record them as incurred. This differs from paying in accordance with the accrual method of accounting.

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Why Are Accrued Expenses Important?

Your company’s financial status and cash flow can be greatly influenced by how you record incurred expenses. This is especially true when we look at the cash basis form of accounting. 

For example, say you own Business X.

In July 2021, Business X did the following:

  • Sent out an invoice for a total of $5,000 for services that they provided that month
  • Received a bill for $10,000 in fees for work completed in the same month
  • Sent out a $5,000 invoice for a deposit for a future project
  • Paid $1,000 in fees for a bill from the previous month
  • Received $2,500 from a client for a project invoiced from the previous month

In this case, Business X uses the cash basis method. The profit for this period would be $1,500. This reflects the $2,500 in income minus the $1,000 in fees. 

But using the accrual method, Business X would record a loss of $5,000. This reflects the income of $5,000 minus the $10,000 in accounts payable. 

This is a perfect example of how your accounting process has a big impact on your financial reports. It also reflects how you perceive the state of your company’s finances.

Advantages of Accrued Expenses

Accrued expenses, in theory, enhance the accuracy of a company’s financial reporting.

You can include activities that may not have been fully incurred but will still take place in your accumulated expenses. The cash technique is less complicated, though.

Think about a scenario where a business signs a contract to pay for consulting services. According to accounting theory, let’s say that a corporation receives an invoice for $50,000. It is technically required to record this transaction because there is a legal obligation to pay for the service. 

In addition, accrued costs might make it simpler for businesses to plan and formulate strategies. Businesses can include recurrent transactions in their financial reporting that they may not have paid yet. So, accrued expenses frequently produce more consistent financial outcomes. 

Accumulated expenses may be a necessity for financial reporting. This depends on the business and its Securities and Exchange Commission (SEC) filing requirements.

Disadvantages of Accrued Expenses

While there are a number of advantages to accrued expenses, there are some downsides too. 

This style of accounting requires extra time and labour from staff to prepare due to the added task of accruing costs. Misstatements are more likely, particularly if auto-reversing journal entries are not employed. Additionally, a business bears the danger of unintentionally incurring a cost that it may already have covered.

The accrual method of accounting muddles cash flow and cash usage. This is because it includes non-cash transactions that have not yet had an impact on bank accounts. 

A large business will have a general ledger that is overflowing with transactions. These will record things that have no impact on the bank statement of the business or the current level of cash on hand.

Accrued Expense vs. Accounts Payable

We call the total amount owed for products and services the business has used or received “accrued expenses”. All businesses have accumulated costs. However, they represent expenses for which a bill or invoice wasn’t received. 

As a result, accruing expenses may occasionally represent an estimate of owings. After receiving the invoice, you may adjust this number to the precise amount.

However, accounts payable represent the overall short-term liabilities or debt. This is debt that a business owes its debtors for goods or services obtained on credit. The vendor’s or supplier’s invoices get received and recorded in accounts payables. The actual amount owed from all the invoices received is then included in payables.

Additional distinctions between these two costs include the following:

  • The beneficiary: Businesses reimburse their workers, property owners, and banks for incurred costs. The most frequent incurred expenses that businesses owe are salaries, rent, and interest. On the other side, accounts payable represent money owed to creditors. This includes finances such as suppliers for products and services.
  • Occurrence: Accrued expenses, such as rent and loan interest payments, frequently occur. However, accounts payable only occur when a business buys something on credit.

Accrued Expenses vs. Prepaid Expenses

Prepaid expenses are the opposite of incurred expenses. Prepaid expenses are payments made in advance for goods and services that you expect to receive or use in the future.

We record prepaid expenses as assets on the balance sheet, as opposed to incurred expenses, which are liabilities. Why? Because a corporation anticipates using the prepayment to its future economic advantage.

An incident that has already happened, however, and where cash was not a factor is an “accumulated expense”. The business has already got the benefit, but it also needs to send the payment. An accrual is the identification of something that has already occurred in which cash was not resolved. Hence, it is the exact opposite of a prepayment.

Example of Accrued Expense

Let’s continue to use the example of Business X.

On the first day of the next month, Business X pays its employees’ salaries for services rendered the previous month. For example, those who worked throughout June will receive their pay in July. The incurred costs for the employees’ services for July will be missed. This is if the company’s revenue statement on July 31 simply records the salary payments made.

We make an adjustment journal entry for the final month’s expense at the end of the accounting period. This is because Business X actually experienced salary costs for 12 months. 

The adjusting entry will include a credit to the salaries payable account on the balance sheet. It also includes a debit to the salary expenses account on the income statement. It’s dated July 31.

The accounts payable account gets credited whenever the accounting department of Business X gets the bill. Meaning the bill for the whole amount of salaries due. 

The balance sheet’s current liabilities column includes accounts payable. This is a company’s short-term liability. After the company pays off the debt, the accounts payable account gets debited and the cash account gets credited.

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Key Takeaways

Companies that use the accrual method of accounting record accumulated expenses. (These are also known as costs incurred but not yet paid for.) By documenting charges, accrued expenses improve the consistency of financial statements.

You need more journal entries for accrual accounting. This is true especially when compared to straightforward cash balance accounting. Compared to cash basis accounting, accrual accounting offers a more realistic financial picture.

Large, publicly traded corporations frequently must adhere to accrual-based accounting standards. 

Prepayments are the recognition of events that have yet to occur but for which cash is already paid. Whereas accruals are the acknowledgement of occurrences for which cash was already paid.

FAQ on Accrued Expense

What Is a Journal Entry for Accrued Expenses?

An incurred expense journal entry often represents a debit to the expense account. Your expenses go up because of the debit input.

Is Accrued Expense an Asset?

We record prepaid expenses as assets on the balance sheet, as opposed to incurred expenses, which are liabilities.

Why Do We Accrue Expenses?

There are a number of reasons, mainly it is because the accuracy of a company’s financial reporting increases due to accumulated expenses.