BAJAJ BROKING
February 21, 2025
7 mins read
To build a successful business or to create reliable financial planning it is important first to understand different economic terms that are commonly used in financial planning. One such term is Accrued Expense. If you have ever analysed a company’s balance sheet or audit book, you must have come across the term accrued expense.
To begin with, accrued expenses are the expenses that are registered on the balance sheet at the time they are incurred rather than the time they are actually paid. Since these expenses are crucial for the company's financial planning, you must understand the meaning and benefits of sorting accrued expenses smartly.
Before moving ahead remember that the term “accrued” itself refers to the recognition of expenses before the cash transaction occurs.
In a nutshell, accrued expenses are those expenses that the company has incurred but not yet paid. These include expenses that are to be made at a future date to clear invoices, salaries, etc, but are recorded in the company’s balance sheet at the start. Since these expenses are not paid at the time of recording, the actual expenses can differ. Remember that these expenses are recorded for the accounting period in which they incur rather than the accounting period in which they are actually paid.
A simple example of accrued expense would be the expenses that a company incurs while purchasing supplies from a vendor without receiving the actual invoice from the vendor. The accrued expense will be recorded when the supplies are purchased and not when the invoice is cleared. Therefore, accrued expenses are usually estimated expenses.
Just like any other accounting method, accrued expenses also come with certain pros and cons that you must bear in mind for efficient financial planning.
Pros of Accrued Expenses
Promotes Efficient Financial Planning
One of the biggest advantages of accrued expenses is that it makes financial planning and strategies easier for the company. This is so because relying on accrued expenses helps the company analyse recurring transactions through their financial reports, which include expenses that may not have been paid yet but the company is under an obligation to pay in the future.
Promises Transparency
Accrued expenses are a reliable sole source for stakeholders to understand the company‘s actual financial condition, thus promising transparency. Stakeholders can better rely on companies' financial status through their financial statements if accrued expenses are included.
Eases Cash Flow Management
Since accrued expenses are calculated to understand and analyse the company‘s financial obligations better, the company can manage cash flow efficiently.
Ensures Accurate Financial Reporting
Accrued expenses are those expenses that may not have been paid yet but the company is under an obligation to pay in future. Therefore, including accrued expenses in the accounts ensures accurate financial reporting.
Cons of Accrued Expenses
Calculations Can be Complex
In most cases companies are involved with numerous accruals for different expenses categories which makes calculating accrued expenses complex.
Potential for Errors
As discussed above accrued expenses are estimated expenses and they can differ from the actual invoices. This might enhance the chance of errors in the company‘s financial reports.
Time Consuming
Accruing expenses is an additional work that a company has to perform thus it becomes time consuming and also demands more staff to work on accruing expenses. Additionally, there is also the risk of accruing an expense the company might have already paid.
Might Blur Cash Flow
Since accrued expenses are non-cash transactions, recording these expenses might blur the company’s cash flow and its understandings. This is so because accrued expenses don’t impact the company’s bank accounts till the time they have been paid but since these expenses are already recorded the company might find it difficult to manage its cash flow.
To help you understand accrued expenses getter, let’s take a few examples that include common accrued expenses across different companies:
Wages and salaries
Every company is under an obligation to pay its employees salaries, bonuses and commissions depending on the type of work employees perform. Now, while the company might have a specific date to give out salaries and bonuses, these expenses are liabilities on the company that comes under accrued expenses and are therefore recorded prior to being actually paid.
Utility payments
In addition to paying wages and salaries, every company also has utility payments that include expenses incurred on electricity, water, gas, etc. Since the company uses these facilities throughout the year, expenses incurred on these utilities are recorded in the accounting period; they are consumed rather than paid in the accounting period when the invoices for these utilities are paid. This comes under accrued expenses.
Interest and rent payments
Business loans, interest paid to stakeholders or rent payments for using digital or physical infrastructure are also often recorded as accrued expenses.
Now, remember that while relying on accrued expenses comes with a key benefit of efficient financial planning, it is vital to bear in mind specific factors to avoid miscalculations. Let’s take a look at two specific factors that companies are cautious about while accruing expenses:
Reversing Entries
A simple rule of accruing expenses is that these expenses are not supposed to be permanent; this is to say that accrued expenses are supposed to be recorded as temporary expenses till the time actual payments are made. Therefore, it is important for the company to ensure reverse entries to back out transactions in the future. This is done to avoid running the risk of duplicating transactions by recording the accrued expense as well as the actual invoice payment.
Month-End/Year-End
In most cases accrued expenses are recorded during the end of an accounting period. Companies are determined to close its accounting payable ledger by booking actual invoices, it becomes easier when the company has a supporting account staff to carefully analyse the actual invoices and include accrued expenses. However, for companies that are responsible for external reporting, it becomes crucial to perform a month-end or fiscal year-end process. However, accrued expenses are not booked during the month-end process but rather during the closing period. This becomes a big consideration for these types of companies.
Building accounts for a company can be done in different ways that includes accrual accounting, cash basis accounting or prepaid expenses accounting etc. Let’s understand the difference between accrual versus cash-based accounting.
Simply put, cash-based accounting records only those transactions or financial events where actual cash is exchanged or a payment is made. Whereas accrual expenses include those expenses that puts an obligation on the company to make a payment in future.
Cash-based accounting is simple but can lead to a blurred understanding of the company‘s actual account balances. On the other hand, accrual method, despite being labour intensive, presents a more accurate picture of the company's financial status.
Prepaid expenses and accrued expenses are completely opposite in their accounting methods. Prepaid expenses include payments of those goods and services that are expected to be used by the company in future. Prepaid expenses are evaluated to include those pre-payments that the company has made for goods and services that would benefit the company in future but have not been received by the company, yet.
Whereas accrued expenses are those expenses whose payment has not yet been cleared but the goods or services have already been received by the company like salaries of the employees, supplies from a vendor who is in voice is not yet cleared, interest or on payments etc.
Relying on accrued expenses helps companies build a more efficient accounting method to ensure better financial planning. Since these expenses include payments that the company is under an obligation to make in future, evaluating these expenses become important. However, it is important to remember that accruing expenses for a company is time and labour consuming and also requires a few considerations like ensuring reverse entries etc. When done efficiently, accruing expenses can present a transparent and reliable picture of the company’s financial status.
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Accrued expenses are recorded in accounting by including all those expenses that the company is under an obligation to pay in future but has not yet paid. Accrued expenses are estimated expenses therefore there are chances that the actual invoice payment might differ from the recorded accrued expense in accounting.
Accrued expenses are those expenses that the company is liable to pay in future for goods or services that the company has already received. Some common examples of accrued expenses are salaries, bonuses or commissions to employees, utility payments, interest and rent payments etc.
Accrual expenses and cash basis accounting differ from each other in their accounting method. Accrual accounting includes those expenses that the company has incurred but not yet paid whereas cash basis accounting include only cash transactions or payments that have already been made by the company.
As the name suggests, prepaid expenses are those expenses that are incurred by the company to make advance payment for goods and services that the company would require in future. Prepaid expense accounting is done to get a clear picture of the company’s finances.
The journal entry process of accrued expenses are done through reverse entries. Under this, accrued expenses are first recognised by debiting the expense account and making an entry of the company's accrued liability. Once the accrued expenses are cleared by making payments, a second journal entry is made to reverse the first entry of accrued expenses. This is done to ensure that the company’s account sheet is not running the risk of making double entries for same expenses.
Accrual accounting is performed by companies to get a clear picture of their financial status. Since accrual accounting includes the evaluation of expenses that the company is liable to pay in future this helps the company in efficient financial planning.
The accrued expenses affect the financial statement as it includes accounting of all those expenses that are to be paid in future but the company is already under an obligation to make the payment. Since these expenses are recorded on financial statements, the company gets a clear picture of their financial status. However, since accrued expenses do not include actual cash transactions, the company’s bank account does not move.
Yes, prepaid expenses can be adjusted over time. These expenses are adjusted on the income statement based on the portion recorded. Once this portion is recorded, the remaining is then recorded on the current balance sheet. Know that this method of recording keeps on going until the whole value of prepaid asset is completely utilised.
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