Accrued Expenses: Definition & Examples
Accrued expenses are unpaid costs at the end of an accounting period which are recorded as liabilities.
What Is an Accrued Expense?
An accrued expense is an expense that has been incurred but not yet paid by the time the books are closed for an accounting period. The matching principle of accounting requires that expenses are recorded in the same period as the revenue they generate, regardless of whether or not the expense has been paid by the company.
Therefore, at month or year end closing – when the company finalises its reporting for the accounting period – an accountant will record adjusting journal entries to report any accrued expenses that have not yet been paid.
An accrued expense account is a liability account. It appears on the balance sheet under the liability header. It is a current liability because accrued expenses should be paid in the near term – in less than 12 months.
Why Accrue Expenses?
Accrued expenses are recorded during adjusting journal entries at month or year end closing in order to adhere to the matching principle of accounting. The matching principle is only used under the accrual method of accounting. There are two methods of accounting: cash and accrual. The accrual method of accounting is the more commonly used accounting method for all but the smallest of businesses. It is required by Generally Accepted Accounting Principles (GAAP).
Accrual Method
Under the accrual method of accounting, revenue is recorded when it is earned and expense is recorded when it is incurred. It doesn't matter when the cash exchanges hands. For example, assume a business sells its product on credit. The business would then be required to record a credit to revenue and a debit to accounts receivable at the time of sale – even though the customer has not yet paid for the product.
Cash Method
Under the cash method of accounting, revenue and expense are only recorded as the cash is received or paid. Using the same scenario from above, a cash method business would not record revenue until the customer actually paid for the product. At that point, the business would record a credit to revenue and a debit to its cash account.
Accrued Expense Journal Entry
A journal entry to record accrued expenses is referred to as an adjusting journal entry. Adjusting journal entries are recorded at month or year end during the time referred to as “closing” – when a company finalises its journal entries and closes its books for the accounting period. Month and year end closing is an important part of the accounting process because the books need to be closed before the month or year end financial statements are prepared and reported.
When the company has incurred an expense that has not yet been paid, that amount is included in its accrued expense adjusting journal entry. The journal entry would include a debit to the appropriate expense account and a credit to the accrued expense account – a liability account. Accrued expense is considered a liability because it is an amount that the business owes to another entity for a good or service already rendered.
Accrued Expense vs Prepaid Expense
An accrued expense is a liability while a prepaid expense is an asset. Both appear on a company's balance sheet. The accrued expense is an expense that has been incurred but not yet paid. The prepaid expense is a prepayment for a good or service that has not yet been delivered. As such, the prepaid expense is a current asset because the company expects to receive something in return for the prepayment over the near term.
An example of a prepaid expense is an annual insurance payment. A business pays its insurance company at the beginning of the year. At that point, it debits prepaid expenses and credits cash. Each month, the business records 1/12 of expense as the service has now been delivered. The monthly journal entries would include a debit to the insurance expense account and a credit to prepaid expense.
Accrued Expense vs Accounts Payable
Accrued expense and accounts payable are both liabilities that appear on a company's balance sheet. Accrued expenses are recorded as an adjusting entry at month or year end to record expenses on the books that have not yet been recorded. Accounts payable are invoices that have been received from a vendor or supplier that have not yet been paid.
An accrued expense can become ‘accounts payable’ in a future period if the invoice was not received by the business by the end of one accounting period – resulting in an adjusting journal entry for an accrued expense. After the expense is recorded in accounts payable, it is no longer necessary to do an adjusting journal entry to record the expense again as an accrued expense.
An accounts payable entry is recorded as a debit to a related expense or fixed asset account and a credit to accounts payable. When the company pays for the item, it debits accounts payable and credits cash.
Is an Accrued Expense a Debit or Credit?
As a liability account, an accrued expense has a natural credit balance. When the adjusting journal entry is first created, the related expense account is debited while the accrued expense account is credited. The credit balance at month or year end is what flows through to the company's balance sheet.
When the adjusting journal entry is reversed at the beginning of the following accounting period, the reverse occurs with the journal entry as well. The accrued expense account is debited and the expense account is credited. This does not cause a debit balance in the accrued expense account, but it rather wipes the account back out to zero as the next accounting period begins.
It leaves a negative (credit) balance in the related expense account. This is counteracted to zero when the cash is paid (a credit) and the expense is recorded (a debit) in the new accounting period – since the expense was recorded in the previous period when it was accrued.
Example of Accrued Expense
Assume ABC Company has a landscaping company come out to do routine yard work and maintenance on their front lawn. They’ve used this company for many years and have a good working relationship with them. The landscapers routinely come out and do work multiple times before sending ABC an invoice for multiple visits. If the landscapers came out on 23rd March and 5th April before sending in an invoice, ABC Company would not have an accounts payable set up for the expense incurred on 23rd March.
Instead, the accountant in charge of the month end closing process would need to record an adjusting journal entry to include the expense for the 23rd March landscaping visit in the correct month - in this case, March. The adjusting journal entry submitted in April would include a debit to lawn care expense and a credit to accrued expenses. The reversal of the adjusting journal entry on the 1st would include a debit to accrued expenses and a credit to lawn care expense.
Additional Resources
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