If you’ve never looked at your business’s financial statements before, it might surprise you to find a liability account in your books called “accrued expenses.” How can an expense be a liability? Is it bad that you have accrued expenses? And how do you pay for them?
Here we’ll go over what exactly accrued expenses are, how to account for them using journal entries, and what they mean for your bookkeeping and accounting operation.
What are accrued expenses?
An accrued expense is an expense that has been incurred within an accounting period but not yet paid for.
There are all kinds of accrued expenses your business might be accumulating without you even knowing it: unpaid vacation pay, unreimbursed employee travel expenses, utilities you’ve used but haven’t been billed for, and more.
These short-term or current liabilities can be found on your company’s balance sheet and general ledger. Depending on your accounting system and accountant, they might also be called accrued liabilities or spontaneous liabilities.
But hold on a second: how is it possible to incur an expense without paying for it? The answer is accrual accounting.
Cash basis accounting vs. accrual accounting**
You only record accrued expenses in your books if you run your business under the accrual basis of accounting.
If you run your business using cash accounting, you record expenses the moment you pay for them, and you won’t have accrued expenses in your books.
What’s the difference between the cash and accrual method of accounting? Timing, mostly:
- Cash accounting recognizes revenue and expenses only when money changes hands
- Accrual** accounting** recognizes revenue when it’s earned and expenses when they’re incurred (but not paid)
To illustrate this, let’s say an employee of yours is purchasing supplies for a staff party in June, for which they’ll be reimbursed on their July paycheck. Your accounting method determines in which month the expenses are recorded.
If you use cash accounting, you won’t record accrued expenses because you’ll only record the expenses once the employee is paid in July. But with accrual, the expenses show up on your income statement in June as your employee purchases the supplies.
Why are accrued expenses important?
Recording accrued expenses (as opposed to sticking with cash basis accounting) can have a big impact on how you understand your business’s financial position and cash flow.
For example, let’s say you did all of the following in the same month:
- Sent out an invoice for $2,000 for a web design project completed this month
- Received a bill for $4,000 in developer fees for work done this month
- Sent a $2,000 invoice for a deposit for a project you intend to start the following month
- Paid $500 in fees for a bill you received last month
- Received $1,000 from a client for a project that was invoiced last month
Using the cash basis method, the profit for the reporting period would be $500 ($1,000 in income minus $500 in fees).
Using the accrual method, you would record a loss of $2,000 for the reporting period ($2,000 in income minus $4,000 in accounts payable).
Your accounting method greatly affects your financial reports and how you understand the financial health of your business. Talking to a CPA can help you choose the method that’s best for you.
How Bench can help
The best financial reporting method for your business is the one you most consistently use. With Bench, your personal bookkeeper automatically imports your bank and credit card transactions to completely automate your bookkeeping process. That means when you need to access your financial reporting, your workload is as easy as logging into your account. Get a free, previous month of bookkeeping completed in one business day with our free trial.
Examples of accrued expenses
Any expense you record now but plan to pay for at a later date creates an accrued expense account in your books. An example of an accrued expense might include:
- Bonuses, salaries, or wages payable
- Unused vacation or sick days
- Cost of future customer warranty payments, returns, or repairs
- Unpaid interest expenses or accrued interest payable
- Utilities expenses that won’t be billed until the following month
- Anything you’ve purchased but haven’t received an invoice for yet
How to record adjusting journal entries for accrued expenses
Let’s say your business, a combination bookshop, record store, and taqueria, rents a brand new street-level retail space. You’ve signed a lease and agreed to pay the landlord $3,000 a month, picked up your keys, and started moving in your equipment. So far, so good.
Fast forward to the end of the month (let’s say it’s February), and you still haven’t heard from the landlord about payment. In fact, you’re having trouble getting ahold of them. She won’t pick up the phone or answer her email, and her answering machine says she’s in Cuba.
You look over the lease and realize it doesn’t actually specify how the landlord would like to get paid or where to send the money. March 1st rolls around, and there’s still no word from her. It becomes clear that you won’t be able to pay the landlord for the first month of rent until she gets back in touch with you.
However, because you use the accrual basis of accounting, your books will still need to reflect the rent expense. So you make the following adjusting entry in your books:
You now carry $3,000 in accrued expenses on your books to reflect the $3,000 you owe the landlord.
Now let’s say the landlord gets in touch a week later.
“Sorry,” she says, “I’ve been relaxing on the beach all week and completely forgot about this. Mind sending me an e-transfer when you get a chance?”
You agree, she deposits the money into her account, and the rent expense has finally been paid. At the end of the accounting period, you close out the accrued expense on your books with the following journal entry:
Accrued expenses vs. prepaid expenses
So accrued expenses are a payable account that is a liability on your balance sheet. But what about the opposite? The answer is prepaid expenses, and they’re actually more common than you think.
Let’s say you just started your business’s social media account. To make sure you’re not adding more tasks to your to-do list like having to check up on it and manually post, you want to invest in a social media management tool. You find one you like, and their pricing page mentions you can save a lot of money by being billed annually. Instead of paying $140 every month, you are billed $1,200 for the full year saving you almost $500.
It doesn’t feel right having a one-time $1,200 payout impact the income statement of one month. You’re actually prepaying for the full twelve months of service, and your accounting can reflect that.
When the payment for the total amount occurs, the journal entry looks like this:
Prepaid expenses are an asset on your balance sheet as it reflects a future value—multiple months of a social media management tool—for your business. Then every month, you need to make an adjustment to reflect the monthly expense of the subscription.