Accrued Expense: Definitions & How It Works
An accrued expense refers to costs that are recognized on the books before they are paid. This accounting method aligns with the accrual basis of accounting, which records financial transactions when they are earned or incurred, not just when cash changes hands.
Accrued Expense Explained
Accrued expense is a term that makes many fledgling entrepreneurs and individuals new to finance scratch their heads. Yet, it’s a vital concept in accounting that you absolutely can’t afford to overlook.
Accrued expenses are those expenses that are recognized in a company’s books before they have been paid.
What does this mean in simpler terms? Well, imagine you run a software company and hire a freelance developer. The developer works for the entire month but invoices you only at the end.
Even though you haven’t paid the invoice yet, you still record this as an accrued expense. Why? Because the service has been rendered, and you owe money for it, making it a liability on your balance sheet.
The benefit of using accrued expenses in your accounting is precision. It gives you a more accurate picture of your financial health by including all financial obligations, whether or not they have been paid yet.
Ignoring them could offer a misleadingly optimistic snapshot of your cash flow, a mistake you don’t want to make when planning for the future.
- Timing Matters: Accrued expenses are all about timing. They allow you to recognize costs in the period in which they occur, ensuring that your financial statements are more aligned with the economic reality of your business.
- Legal Obligation: It’s not just about noting an expense. Accrued expenses mean that a legal obligation has arisen. You are legally required to settle this payment at a later date.
- Impact on Taxes: Accrued expenses can also affect your taxable income. By accurately reflecting your total obligations, they may potentially lower your tax liability for a specific period.
An Example Of Accrual Expenses
Here are some examples of accrual expenses:
Salaries: Employees work the entire month, but the payment is usually made at the beginning of the next month. The salaries for the month that have yet to be paid are accrued expenses.
Utilities: You consume electricity for a whole month, but the bill often arrives the following month. The cost of electricity consumed but not yet billed is an accrued expense.
Consultant Fees: Say you hired a marketing consultant whose payment is due after the delivery of a final report. Even if the report is done but you haven’t paid, the fee becomes an accrued expense.
Accrued Expenses Vs. Accounts Payable
Here are some of the differences between accrued expenses and accounts payable:
|Criteria||Accrued Expenses||Accounts Payable|
|Definition||Expenses that have been incurred but not yet paid.||Amounts owed to suppliers for goods or services purchased on credit.|
|Timing||Recorded in the period they are incurred.||Recorded when invoice is received.|
|Legal Obligation||Yes, a legal obligation exists.||Yes, but generally formalized through an invoice.|
|Effect on Financial Statements||Impacts both the income statement and the balance sheet.||Primarily impacts the balance sheet.|
|Tax Implications||Can affect taxable income by accurately reflecting total obligations.||Generally no direct impact on taxable income, but failure to pay can result in penalties.|
Is an accrued expense a liability?
Yes, an accrued expense is a short-term liability. You’re obligated to pay it, making it a debt that needs settling.
When are accrued expenses recorded?
They are recorded during the accounting period in which they are incurred, even if payment is to be made later.
How do you reverse an accrued expense?
Once you’ve paid off an accrued expense, you need to reverse the entry in your accounting books. This usually involves crediting the accrued expenses account and debiting the cash account.