The accounting entries that record the expenses upon the actual occurrence of the expense are termed accrued expenses, although the payout has not been received. This method of accounting ensures that expenses are recorded within the period when they occur, and thus it offers better financial information compared to cash-based accounting.
What Are Accrued Expenses?
The accrued liabilities are expenses incurred by a company and which are yet to be paid at a specific time, which is the end of some accounting period. They play a critical part in accrual accounting, where it is required that the expenses be matched with the revenues of the same period, regardless of whether the cash was received or not. In contrast to the cash basis accounting method, where expenses are recorded when they are paid, the accrual method of accounting records all liabilities and obligations as they accrue.
Accrued expenses are recognized in the current liabilities section of the balance sheet as they are likely to be paid in the next few days. Examples are salaries, utility bills, and interest on loans that are yet to be paid, billed, and paid, respectively.
Key Examples of Accrued Expenses
- Salaries and wages of employees: In the scenario where the workers have worked in a month but are paid at the end of the next month, the salary accrues at the end of the month.
- Utility bills: Utility bills are accrued throughout the accounting period before being billed.
- Interest charges: This is a charge of interest on loans that are accrued over a duration until it is paid off.
- Taxes: Taxes are payable on an accrual basis, but are payable after the reporting date.
- Commissions or bonuses: These are earned by the employees or the sales agents but paid in the future.
Recording of Accrued Expenses: How?
The entries in the average journal of an accrued expense refer to debiting the corresponding expense account and crediting the accrued liabilities account. Consider the case of a utility bill incurred in June and paid in July of 10,000 US dollars:
- Debit Utility Expense $10,000
- Credit Accrued Liabilities (or Accrued Payables) $10,000
- As the payment is made in July, it reverses the accrued liability:
- Debit Accrued Liabilities $10,000
- Credit Cash $10,000
The reversal entries play a crucial role in preventing the invoices that have been received from being counted twice.
Impact of Accrued Expenses on Financial Ratios
The implication of the accrued expenses to the various financial ratios that analysts and investors employ to determine the performance and well-being of a firm is as follows. Next, to explain the case, increased accrued liabilities will decrease the current ratio of the firm, and it will have lower short-term liquidity. Similarly, the accrued expenses accounting affects the profitability ratios such as the net profit margin, as the accrued expenses will be recorded and the cash outflows will be awaited. The understanding of the effect of those rates of accrued expenses will help the management and other interested parties to read the financial statements in a more accurate and effective manner.
Precision and Perfect Practices In Managing An Expense
Many firms have struggled to maintain the accuracy of accrued expenses. The common errors are enumerated as: failure to record all expenses incurred, reversing of entries, and counting expenses twice when invoices are received. The best practice that might have been adopted to avoid such errors includes:
Payment and expense reports are reviewed efficiently and on time to the eve of reporting periods.
Carrying out accruals, reversals using accounting software, and attempting to reduce the number of manual errors.
Training accounting workers about the nature of recording and reconciling accruals.
Regular reviews are made to determine that the accrued expenditure is fair, precise, and compliant with accounting principles.
Accrued Versus Prepaid Expenses
Whereas accrued expenses reflect the obligation that has not yet been paid, prepaid expenses reflect those that have already been paid but have not yet been received, in the form of goods or services. The difference between pre- and accrued expenses is that the former is an asset first recorded and later charged over time, but the latter is a liability recorded to show expenses that have been incurred before.
Benefits of Using Accrued Expenses
- Proper Financial Reporting: Gives a clear picture of financial health as it compares expenditure to the time frame it relates to.
- Consistency: Will produce more uniform month-by-month financial statements.
- Better Decision-Making: aids the management in the process of better financial planning and performance analysis.
- Compliance: Adheres to generally accepted accounting principles (GAAP) and reporting regulations.
Disadvantages and Challenges
- High Complexity: More journal entries and record-keeping are required.
- Risk of Materials: These misstatements have a risk of being made, particularly when reversing entries are ignored, thus creating duplication of expenses.
- Cash Flow Blurring: Non-cash transactions are part of the accruals that may not reflect the real position of the cash flow of the company.
Final Thoughts
Accrued expense plays a very significant role in the accrual accounting system because it is essential to reflect the liabilities of a company and also to show the financial statements that reflect an economic reality rather than financial flow. They are less reliable and compliant than cash basis accounting, although they are more labor-intensive, and their benefits outweigh the drawbacks of the system.
