What are Accrued Expenses? - Definition and Examples

Accrued expenses means the costs that are recognised in the books of the organisation before they are paid. This means the expenses are recorded when they are incurred, even though they are paid later.

An example of accrued expense is the rent for the business premises. The rent is recorded in a particular accounting period, even though the payment is made later. Once the payment has been made, the books are updated to reflect the payment, and a balance owed, if any. Other examples can include costs such as utilities, wages, and interest.

What Are Accrued Expenses?

As seen above, these are costs that are recognised in the financial statements during the accounting period in which they are incurred, even if the payment has not yet been made. To explain accrued expenses simply, they are the expenses incurred by a business that have yet to be paid. They. This method is called the accrued accounting method and is the preferred account method of Generally Accepted Accounting Principles (GAAP).

What Does the Term ‘Accrued’ Mean in Accounting?

The term ‘Accrued’ in accounting means to accumulate over time. Accrual can be incurred (expenses) or earned (income). Both assets and liabilities accrue over time. The term accrual is used while referring to interest, expenses, and income. Accrual can refer to accrued revenues or accrued expenses.

Accrual accounting, as opposed to cash accounting (which is the practice of recording income/expenses when they are paid), gives a more accurate picture of a company’s financial health.

Examples of Accrued Expenses

Understanding accrued expenses basics is easy with the below examples.

• Utility: An accrued expenses example is a utility, such as electricity, water, and gas. The utility services are consumed throughout the accounting period and are hence recorded during the particular period, even though the payment is made later.
  If a company’s electricity bill is generated every quarter, the payment is made only every 3 months. However, the accrued expenses are recorded as soon as they accrue, not when the actual payment is made.
• Wages and Salaries: Wages and salaries of employees are another example of accrual. The wages are recorded during the payroll period before the wages and salaries are paid to employees.
  For example, if a payroll cycle is from 1st January to 31st but the payment is processed on the 5th of February, the wages are recorded in January once the pay is accrued.
• Rent: Rent is an example of accrued expenses. The rent is recorded as soon as it is accrued every month before it is paid.
  For example, if the rent period is 1st to the 31st of January, but the rent is paid on the 15th of February, the rent is accrued for and recorded in January.
• Taxes: Taxes are another example of accrued expenses. As per the accrual method, taxes are recorded in the month in which they become due, rather than at the time of payment.
• Interest: To understand how accrued interest works, we can use a Bond as an example. If a company borrows INR 1,00,000 from a lender on June 20 at 9% annual interest, the monthly interest is INR 750. The interest for the 10 days of June is calculated as (750*10/30) INR 250. This amount is recorded for June as an interest expense by the company, even though it is paid out later.

Accounting Treatment of Accrued Expenses

As a potential investor or debtor, one needs to understand the company’s statements to make a decision based on the financial health of the company. Understanding the accounting treatment will help assess the company’s financial health based on its expenses and income.

In accounting, accrued expenses appear as a liability on the balance sheet and expense on the income statement. In the journal entry, expenses are debited showing the cost of products or services used, and the accumulated liability account is credited to show the business’s future liability to pay.

At the end of a particular accounting period, the recorded accrued expenses are adjusted against payments (partial or full) to reflect the amount owed, to ensure that the financials are correctly portrayed.

How Are Accrued Expenses Different From Accounts Payable?

Both accrued expenses and accounts payable are liabilities to a company, however there are some differences between the two.

Simply put, accrued expenses are expenses that have occurred but are yet to be paid for and no invoice has been received. Accrued expenses are generally paid within a specific window set by the company. Expenses such as payroll, utilities, etc are accrued expenses.

On the other hand, accounts payable is the amount owed by the business to suppliers for products purchased on credit. Accounts payable are generally more flexible. Purchases, labour costs, freight charges, etc are the costs associated with accounts payable.

The below-outlined example can help understand the difference:

In the case of a business procuring raw materials from a supplier, as soon as the raw material is received, the amount becomes due. In this case, the accounts payable balance increases until a payment is made.

In another scenario, if a business is consuming electricity from the provider, the services are being consumed but the invoice is not yet generated. This is recorded under accrued expenses until an invoice is issued and payment is made.

Advantages of Accrued Expenses

Outlined below is the overview of accrued expenses advantages:

• GAAP compliant: The accrual accounting method is the preferred accounting standard for GAAP. Using accrued expenses sets businesses up to be GAAP compliant when they need to be.
• Transparent: Accrual accounting gives a transparent picture of the company’s business financials, as the transactions are recorded as soon as they are accrued. This gives potential investors and debtors information to make investing and lending decisions.
• Enables strategic planning: Accrual accounting gives a clear view of the company’s future cash flow, thus enabling leaders to form strategic plans.

Disadvantages of Accrued Expenses

• Complex: Accrual accounting is more complex than cash accounting, which involves recording transactions when the payment is made. The regulations set out in GAAP around accrual accounting are complex to implement and might require assistance from a professional accountant.
• Difficult to Switch: For businesses using other accounting standards, it can be difficult to switch to accrual accounting. It can be especially challenging for businesses having cash flow issues to switch to accrued accounting.
• Potential Errors and Fraud: It can be challenging for businesses to estimate accrued expenses, particularly before invoices are generated (For example, utilities). Also, businesses operating without proper processes and controls in place might be susceptible to fraud.

Impact of Accrued Expenses on Business Loans

Businesses that are in the practice of recording accrued expenses can be viewed favourably by lending institutions. This is because, apart from being transparent and having an accurate portrayal of the financial health, the lender is assured that accrued interests on loan repayments are budgeted for, increasing the creditworthiness of the business.

Business Loan Considerations

When considering a business loan, it's essential to understand how accrued expenses impact your financial health and borrowing capacity. As they are liabilities for services or goods received but not yet paid for, and they can affect your cash flow and overall financial picture.

High accrued expenses might indicate potential cash flow issues or operational inefficiencies, which can influence loan approval decisions. It's crucial to manage these expenses effectively and maintain accurate records to present a clear picture of your financial stability.

Conclusion

A way of recording the expenses of the business when they are incurred, accrued expenses give an accurate representation of a business’s financial health. Even though it may seem complex to implement, if done with the correct approach, it can boost the creditworthiness of a business that is looking at accessing business loans.

If you are looking for a business loan to manage your finances more effectively, SMFG India Credit offers tailored business loan solutions at competitive interest rates. Apply online today or contact us for more details.