Accrued expenses: what they are and how they impact business accounting
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Proper accounting is crucial for a business owner to maintain comprehensive records of their transactions and have a true understanding of the overall financial health of the company. To that end, accrued expenses are key to keeping the books accurate.
In this article, we'll break down what constitutes an accrued expense, offer some examples, and explain how it differs from other types of expenses and features of the accounting process. We'll also outline best practices for recording and managing accrued expenses.
What accrued expenses are and are not
An accrued expense is a payment or liability that a business has incurred but not yet paid for. Also known as accrued liabilities, these expenses are recognized in a company's accounting records before the transactions are actually processed. So put simply, a business might have received goods or services but not the invoice for them. Even before that bill arrives, however, the expenses will still be recorded on the balance sheet.
A common example of an accrued expense is employee salaries. Typically, a business pays its employees once or twice a month for their previous 2-4 weeks of work, which means these workers have rendered services before receiving payment. Prior to payday, the company would record those paycheck amounts in its financial records as accrued expenses, as the outflow of cash has not yet taken place.
Another example might be a one-year insurance policy, wherein the business recognizes each monthly payment as accrued expenses even before making the transaction.
Accrued expenses vs. accounts payable
The term accounts payable is similar to accrued expenses in that both are liabilities. While accrued expenses represent money a company owes for goods or services it has already received but not yet been billed for, accounts payable refers to money the business owes for goods or services received on credit. So, accounts payable are liabilities that the company has been billed for and must pay within a certain time period. An example might be inventory from suppliers who have issued an invoice for their goods.
Accrued expenses vs. prepaid expenses
Prepaid expenses might be considered the opposite of accrued expenses. As the name suggests, they're expenses that have been paid in advance for goods or services that'll be provided at some point in the future. So the company will eventually benefit from these expenditures – as with utilities, insurance, or rent paid in advance.
Accrued expenses vs. outstanding expenses
Outstanding expenses are also known as unpaid expenses or unpaid bills. These are costs incurred and invoiced. Basically, the company has received a bill for goods or services but has not yet paid it. In contrast, accrued expenses are incurred but not invoiced. Both will presumably be paid in the future, but only one is currently owed.
Why accrued expenses matter in accounting
Accrued expenses are an important part of a company's financial records for multiple reasons.
Accounting for them helps ensure the balance sheets are as precise, accurate, and up-to-date as possible. Accrued expenses also give business owners a fuller picture of their financial obligations so that they can budget and manage cash flow properly.
There also might be tax implications to accrued expenses, as they could be deductible in the present tax year. Recording accrued expenses is also useful in the event of an audit or financing move that subjects the accounting books to greater scrutiny.
How to record accrued expenses in a journal entry
Accrued expenses are recorded using the journal entry accounting method, so the costs are recognized in financial statements during the period when they are incurred, rather than when they're paid later. To create a journal entry, identify the expense, determine the specific amount, and then document it by debiting your accrued expense account with that amount and crediting the same to the relevant liabilities account. If your company’s $2,000 electricity bill is not yet due, for example, you would debit $2,000 to the accrued expense account for utilities and credit $2,000 to the liabilities account for utilities.
Are accruals an asset or a liability?
An accrued expense is an example of a liability, rather than an asset. That is because it represents money the company will eventually have to pay another entity.
Do accrued expenses go on the income statement?
Accrued expenses go on the expenses section of an income statement and the liabilities portion of a balance sheet. Basically, recording a journal entry involves debiting an expense account and crediting a liability account. Once that accrued expense is paid, you reverse the entry by debiting the liability account and crediting the asset account.
The advantages and disadvantages of accrual accounting
Accrual accounting is one of the two most popular accounting methods, along with cash-based accounting. While the former records expenses as soon as they are incurred, the latter only records expenses once they are paid out. Below are some of the advantages and disadvantages of accrual accounting.
- The accrual method provides a more consistently accurate picture of a company's financial situation and profitability by accounting for all assets and liabilities at any time. This allows business owners to make more strategic decisions to grow the company in a sustainable way. They might be better equipped to budget for later expenses, negotiate preferable deals with suppliers, and forecast future profits. Cash-based accounting, by contrast, offers more limited insights.
- Using accrual accounting can make it easier for businesses to attract investors, as they have more accurate information to share. Under the SEC's generally accepted accounting principles (GAAP), publicly traded companies are, in fact, required to use the accrual method. This method follows GAAP's matching principle, which requires that expenses be recorded in the same period in which revenue is earned from them.
- Accrual accounting is more complicated than cash accounting and thus requires additional time and effort to keep track of various liabilities, accounts payable, and more. The complexity also means a greater chance of making errors in your accounting.
- This method also poses challenges when it comes to managing cash flow. Because accrual accounting includes payments that don't reflect an actual transfer of cash in real time, business owners might have trouble determining how much cash they have on hand at any given time.
How to manage accrued expenses
Accrual accounting allows businesses to more efficiently track and record accrued expenses, which gives a more accurate picture of a company’s financial situation. Below is a step-by-step guide to the accrued expense management process.
Identify accrued expenses
Go through your company’s expenses to identify those that the business has incurred but not yet paid for. Look out for things like rent, utilities, salaries, and miscellaneous fees that might reflect goods or services you’ve already received but not yet been billed for.
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 to ensure accuracy, and keep your documentation organized to prepare for any potential audits.
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 ensure they are accurate and up to date. Good software also allows for seamless budgeting and payment planning with regular reports that accurately reflect a company’s current financial picture.
Another benefit of this system is that it saves the time and resources it takes to manually update spreadsheets and otherwise stay on top of these transactions. Using software reduces opportunities for human error and takes the guesswork out of managing finances. It also better prepares companies for potential audits.
Conduct reviews to ensure compliance
To keep your accrual accounting system running smoothly and correctly, conduct periodic check-ins to confirm accuracy in the recording and make any needed adjustments. Make sure your system is operating in compliance with the applicable industry standards.
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 the company’s financial picture.
Streamline your expense management with Ramp
Ramp’s expense management software is an ideal tool for business owners looking to make the accrual accounting process more seamless. In addition to saving time and boosting accuracy, the system offers a number of helpful features:
- Ramp’s software automates the expense receipt process by allowing employees to submit their receipts on the go with a simple photo and memo.
- The system also collects receipts directly from integrated apps like Outlook, Uber, and Amazon Business.
- Ramp auto-generates expense reports rather than requiring tedious manual data inputs.
- You can rest easy knowing the software will detect errors like duplicate receipts or other accounting inaccuracies.
Get Ramp and say goodbye to the frustration of manually managing your company’s complex expenses.