What is an accrued expense?
An accrued expense is an expense recorded in a company’s accounting records when the asset is used rather than when the related payment is made. Accrued expenses are also known as accrued costs and accrued liabilities.
Examples of accrued expenses
Common examples of accrued expenses include:
- Labour costs (employee and freelance)
- Utility costs
- Purchases made but not yet invoiced by the supplier
Let’s say that a travel company knows that December is its busiest period.
It, therefore, offers its permanent employees overtime. It also takes on seasonal employees and hires freelancers to help with certain key tasks.
Even with this extra help, the company has to work very long hours to meet the demand. It, therefore, invests in new equipment to help lighten the workload. The equipment is sent immediately with the invoice to follow in the supplier’s next billing cycle.
All of these extra costs only become payable in January. The company, however, chooses to record them as accrued expenses. So, it enters the expenditure into its accounting software in December. In some cases, this means the company has to estimate how much the cost will be.
Why use accrued expenses?
The main benefit of accrual accounting is that it creates a real-time record of a company’s financial activities. This means accounting records provide stakeholders with a much clearer and more accurate picture of a company’s financial health.
With cash-basis accounting, by contrast, there can often be a significant delay between an expense incurred and the associated payment made. This can lead to income appearing higher than it is and liabilities appearing lower than they are.
This can make it difficult for business owners and managers to create accurate forecasts. In particular, it can lead to difficulties with cash flow and future tax liability.
The drawbacks of using accrued expenses
The main drawback of using accrual accounting is that it is more complex than cash basis accounting. This means it creates more work, meaning more potential for mistakes.
As a result, accrual accounting is generally only used by larger businesses. Smaller businesses will typically use cash basis accounting.
How to record accrued expenses
Accrued expenses are recorded on a company’s balance sheet under current liabilities.
The difference between accrued expenses and prepaid expenses
Accrued expenses are the opposite of prepaid expenses. With accrued expenses, assets are used and then paid for. With prepaid expenses, assets are paid for in advance and then used.
The difference between accrued expenses and accounts payable
Both accrued expenses and accounts payable are recorded on a company’s balance sheet under current liabilities.
The difference between them is that accrued expenses are accumulated liabilities. In other words, they are costs that have built up over time. By contrast, accounts payable are specific, fixed costs that need to be paid in the near future.
Sometimes accrued expenses can be converted into accounts payable. For example, if a company rents some equipment, it may record the cost of the rental as an accrued expense until it receives the invoice from the supplier. Once the invoice is received, however, the item can then be moved to accounts payable.
Using accrual accounting for income
You can also use accrual accounting to record your income. Exactly the same principles apply, they are just applied in reverse.
For example, if you provide goods or services in December but know that your client will only pay in January, you can still record the income in December.
In this instance, however, you would record it as a current asset rather than a current liability.
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