If you’ve never looked at your business’ 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, 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, etc.
Accrued expenses are short-term or current liabilities that you can find 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 under 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 cash and accrual accounting? It mainly has to do with timing:
- 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)
Why are accrued expenses important?
Recording accrued expenses (as opposed to sticking with cash basis accounting) can have a big impact on the way your business reports its revenues.
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 intent 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 this month would be $500 ($1,000 in income minus $500 in fees).
Using the accrual method, you would record a loss of $2,000 for this month ($2,000 in income minus $4,000 in accounts payable).
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, 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 spanking new street-level retail space. You’ve signed a lease where you 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 a hold 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. To close out the accrued expense on your books, you’d make the following journal entry: