Accrued expenses: Definition, examples, and why they’re important

Picture this: Your company's office cleaning service comes in every week, but you won't receive their invoice until the end of the month. Meanwhile, your employees are working overtime on a big project, earning extra pay that won't hit your payroll system until next week's processing cycle.

These expenses are real and happening right now, even though no money has changed hands yet. This is where accrued expenses come into play. They help you track what you owe before bills actually arrive.

In this post, we'll explain what accrued expenses are, offer some examples, and outline best practices for recording and managing accrued expenses.

What are accrued expenses?

Accrued expenses are expenses your business has incurred that you haven't yet paid. In accrual accounting, you recognize accrued expenses on your books before you've actually paid them, providing a more realistic and accurate view of your finances.

Employee salaries are a classic example of an accrued expense. Let’s say you pay your employees twice a month for their previous two weeks of work, which means your staff rendered services before receiving payment. Prior to payday, you would record those paycheck amounts in your records as accrued expenses because there hasn’t been any cash outflow yet.

Accrued expenses fall under current liabilities on your balance sheet since payment is typically due within a year. This placement helps investors and auditors understand short-term obligations that may not yet appear in your accounts payable.

Examples of accrued expenses

Any expense you know you’ll incur but expect to pay later qualifies as an accrued expense. Here are some common examples of accrued expenses:

• Wages, salaries, and bonuses
• Rent payments
• Utility expenses
• Accumulated interest on loans or business lines of credit
• Monthly insurance premiums
• Estimated taxes for a given period
• Employee expenses that haven’t yet been reimbursed
• Unused sick or vacation time for employees
• Anything you’ve purchased but haven’t received an invoice for, including materials, office supplies, equipment, or services

Why do accrued expenses matter?

Accrued expenses are an important part of your company's financial records for a few reasons.

Accounting for accrued expenses provides a more accurate picture of your company's financial situation by accounting for all assets and liabilities at a given time. This helps you make more strategic decisions about how to sustainably grow your company. It can also equip you to budget for later expenses, manage cash flow, and forecast future profits.

Your accrued expenses might also have tax implications because some of them could be considered business tax deductions in the present tax year.

Accrued expenses are also required under the GAAP matching principle. This mandates that expenses be recorded in the same period as the related revenue, regardless of when payment occurs. This ensures financial statements accurately reflect your company's true financial position during each accounting period, maintaining consistency across reporting periods.

Finally, recording accrued expenses is also useful in the event of an audit or financing move that subjects your accounting books to greater scrutiny. It demonstrates that your business follows proper accounting principles and maintains accurate financial records that reflect all obligations, even those not yet invoiced or paid.

Accrued expenses vs. other accounting terms

Accrued expenses are similar to three other accounting concepts:

1. Accounts payable
2. Prepaid expenses
3. Accrued liabilities

Here are the similarities and differences between each at a glance:

Now let's take a look at each in more detail.

Accrued expenses vs. accounts payable

Accounts payable and accrued expenses are similar because both represent liabilities. The key difference lies in timing and documentation.

Accounts payable represents money your business owes for goods or services you've already received and been invoiced for. It deals with formal invoices sitting in your system awaiting payment. Accrued expenses cover costs incurred without invoices yet, such as employee wages earned but not paid.

Use accrued expenses when tracking obligations before bills arrive, ensuring accurate period-end financials. Use accounts payable for managing actual invoices and payment schedules. Both appear as liabilities on your balance sheet, but accrued expenses require more estimation, while accounts payable involves concrete amounts from vendor invoices.

Accrued expenses vs. prepaid expenses

Prepaid expenses might be considered the opposite of accrued expenses. They're payments made in advance for goods or services you'll receive later, such as annual insurance premiums or software subscriptions paid up front. These are assets on your balance sheet until consumed.

The timing works in reverse: Accrued expenses involve receiving benefits before paying, while prepaid expenses involve paying before receiving benefits. Cash flow impact differs, too. Accrued expenses preserve cash flow temporarily, while prepaid expenses require immediate cash outlay.

For businesses, this affects budgeting and cash flow management. Accrued expenses help smooth cash flow but require careful tracking to avoid surprises. Prepaid expenses require up-front investment but provide predictable future costs.

Accrued expenses vs. accrued liabilities

In practice, these terms are often used interchangeably, but there's a subtle technical difference:

• Accrued expense: Refers to the cost that has been incurred but not yet paid. It's the expense side of the transaction that appears on your income statement.
• Accrued liability: Refers to the obligation to pay that expense. It's the liability side that appears on your balance sheet.

They're two sides of the same coin. When you record an accrued expense (a cleaning service), you simultaneously create an accrued liability (the amount you owe to the cleaning company). The expense hits your profit and loss statement, while the liability sits on your balance sheet until you pay it.

Most accountants and business professionals use the terms interchangeably in everyday conversation because they're referring to the same underlying transaction. You'll see both terms in accounting software and financial reports, but they're describing the same economic reality from different accounting perspectives.

Accrual vs. cash basis accounting

Whether you recognize accrued expenses on your income statement depends on the accounting method your business uses. The two major accounting methods are cash basis accounting and accrual basis accounting.

The main difference between cash and accrual accounting lies in when you record expenses and revenues in your books:

• Cash basis accounting: You report revenues on your income statement only after you’ve received payment from your client or customer. Similarly, you only record expenses when you pay them out, regardless of when you purchased the goods or services. For that reason, accrued expenses don’t exist in cash accounting.
• Accrual basis accounting: With the accrual accounting, you report revenues as soon as you’ve delivered goods or services with the expectation that payment will follow. The same goes for your expenses: You record expenses as soon as you’ve made a purchase, regardless of whether you’ve paid for them. This practice forms the basis of accrued expenses.

Accrual accounting is usually preferred by larger businesses and is required for GAAP compliance. It provides a more accurate picture of financial performance by matching revenues and expenses to the periods when they actually occur, regardless of when cash changes hands.

For larger businesses, this accuracy becomes essential when managing complex operations with multiple revenue streams and varied payment schedules.

GAAP also mandates accrual accounting because it maintains consistency and comparability across the business. The matching principle requires expenses to be recorded in the same period as related revenues. This gives stakeholders confidence that financial statements accurately represent the company's economic reality rather than just cash movements.

How to record accrued expenses

Accrued expenses are recorded using the journal entry accounting method. This ensures the costs appear in your financial statements in the reporting period when they’re incurred rather than when they're paid.

Journal entry for accrued expenses

To record an accrued expense, start by identifying the unpaid cost and the amount your business owes. Then create a journal entry by debiting the relevant expense account and crediting the appropriate liability account.

For example, if your company’s $2,000 electricity bill is not yet due, you would debit $2,000 to your expense account for utilities and credit $2,000 to your liabilities account for utilities:

Once that accrued expense is paid, you reverse the entry by debiting the accrued liability account and crediting the expense account.

Reversing entries and period-end procedures

Reversing entries are the accounting equivalent of hitting the reset button. They automatically reverse accrued expenses at the start of the next period, preventing double-counting when you pay the actual bill.

For month-end procedures, review all unpaid invoices and estimate expenses incurred but not yet billed. Year-end accruals require extra attention to completeness and accuracy since auditors will scrutinize these entries.

The most common mistake is forgetting to reverse entries, which creates inflated expenses in subsequent periods. Another frequent error is inconsistent timing. Establish clear cutoff dates and stick to them across all departments.

Common pitfalls and best practices

Accrual accounting relies on precision, but small missteps can lead to reporting gaps, misstatements, or wasted time during close. Here are some common pitfalls and best practices to help you stay on track:

• Missing obvious accruals: Utilities, professional services, and recurring expenses often get overlooked. Maintain detailed checklists and assign clear ownership for each category.
• Double-counting expenses: Expenses spanning multiple periods can sometimes be recorded twice. Set up monthly reviews to catch patterns and establish consistent cutoff dates.
• Poor documentation: Vague entries leave your team guessing months later. Document your reasoning and supporting calculations thoroughly for future reference.
• Being too conservative with estimates: Understating expenses makes profits look artificially high and creates budget variances. Communicate regularly with department heads who know about upcoming expenses before bills arrive.
• Being too aggressive with estimates: Overstating expenses unnecessarily depresses current results and creates artificial improvements in future periods. Use historical data and vendor quotes to ground your estimates in reality.

By staying alert to these common issues and implementing these practices, you'll build a more reliable accrual process for your business.

Pros and cons of recording accrued expenses

Recording accrued expenses brings significant benefits to your financial reporting, though it also introduces some challenges that require careful attention and consistent management practices. Knowing where these entries help and where they can cause friction helps you build a more effective close process.

While accrued expenses require additional effort to manage properly, the financial accuracy and business insights they provide typically outweigh the administrative challenges.

Special considerations for accrued expenses

Certain situations require extra care and attention when managing accrued expenses. Two key areas that deserve special focus are accounting method transitions and handling significant accrual amounts.

Transitioning from cash to accrual accounting

Implementing accrued expenses requires careful planning. You must identify all outstanding obligations at the cutover date and establish proper accrual processes going forward.

This shift often reveals previously hidden liabilities and provides a more accurate picture of financial performance, though it may initially show lower profits as all expenses become visible.

Handling large or unusual accruals

This demands extra attention and documentation. Multiple team members should review significant accruals and provide detailed calculations and evidence to support them.

Consider breaking down large amounts into components and establishing clear approval thresholds. Document the rationale thoroughly because auditors will scrutinize these entries and disclose them properly in financial statements when the amounts are material.

How to manage accrued expenses

To get the benefits of the accrual method of accounting, you need a process for properly managing accrued expenses. Below is a step-by-step guide to the accrued expense management process:

Step 1: Identify your accrued expenses

Go through your company’s expenses to identify the ones your business has incurred but not yet paid for. Look out for things such as rent, utilities, salaries, and miscellaneous fees that might reflect goods or services you’ve already received but haven't yet been billed for.

Step 2: Document the expenses

The next step is to document these accrued expenses in your accounting system using the journal entry system outlined above. Check that you have the accurate amounts to debit and credit the relevant accounts. Try to make these records as early in the process as possible for accuracy, and keep your documentation organized to prepare for any potential audits.

Step 3: Implement an accrual accounting system

Expense management software can help you identify and track accrued expenses in real time. You can set up entries for known recurring expenses and use the technology to make sure they’re accurate and up to date.

Step 4: Conduct reviews to maintain compliance

To keep your accrual accounting system running smoothly and correctly, conduct periodic check-ins to confirm the accuracy of your entries and make any necessary adjustments. Make sure your system is operating in compliance with the applicable industry standards.

Step 5: Schedule and record payments

Don’t forget to schedule your actual payments for the proper time. Document these payments and make sure the amounts correspond to the accrued expense records, or make the proper adjustments to update your company’s financial picture.

By following these steps consistently, you'll maintain accurate financial records and gain better visibility into your company's true financial position, making informed business decisions easier and more reliable.

Use Ramp to streamline accrual accounting

Ramp’s accounting automation software is the ideal tool for business owners looking to make their accounting processes more efficient. Our modern finance operations platform saves time and reduces errors with features like:

• Automated expense reporting and approvals, including OCR-powered receipt matching
• Extensive integrations with the apps you already use in your tech stack, including accounting tools and ERPs like NetSuite, QuickBooks, and Sage Intacct
• AP automation that allows you to record, approve, and pay every invoice without any manual data entry

Watch our demo video to learn more about how Ramp customers save an average of 5% a year across all spending