What it means
Imagine a company that pays salaries on the first of each month for the month just ended. On the last day of the month, the staff have worked but have not been paid.
The accrued expense records that obligation in the correct period, even though the cash will leave the bank account later. Accruals exist because invoices and payments rarely line up neatly with the calendar.
A supplier may bill quarterly, a bonus may be paid after year end, or a utility bill may arrive weeks after the meter was read. Recording the cost when it is incurred keeps each period's expenses honest.
The entry is simple in principle. The business debits (increases) the expense account and credits (increases) a liability called accrued expenses or accrued liabilities.
When the bill is eventually paid, the liability is cleared and no further expense is recorded, which prevents double counting. Because the real invoice has not yet arrived, accruals are often estimates.
Accountants base them on contracts, past bills or the time elapsed, and they adjust the figure once the actual amount is known. Small differences are normal, but a large or repeated gap suggests the estimation method needs improving.
Accrued expenses differ from accounts payable. Accounts payable relates to invoices that have been received and recorded, while accrued expenses relate to costs for which no invoice exists yet.
On the balance sheet, both normally appear as current liabilities, but analysts watch accruals for signs that costs are being delayed or understated. Controls matter here because accruals are a favourite place for errors and manipulation.
Leaving out a known cost makes profit look better, while over-accruing in a good year can create a hidden cushion to release later. Reviewers therefore ask for support such as contracts, payroll records or emails for every material accrual.
In practice
Real-world examples
Example 1
A retail chain's electricity bills arrive six weeks after the meter reading. At the end of each quarter, the finance team estimates the unbilled usage from past bills and records an accrual. When the invoice arrives, the difference is adjusted, and the team uses the gap to improve next quarter's estimate.
Example 2
A sales team earns commission on deals closed in the fourth quarter, but the company pays commission in February. The finance team records the commission as an accrued expense at year end. Profit for the year then includes the true cost of the sales, so the sales team's results are not flattered.
Example 3
A consulting firm engages a lawyer to review a contract in December. The lawyer will send the $7,500 bill in January, but the work has been done. The firm accrues $7,500 in December so that the expense is recognised in the right year, even though the cash will not leave until January.
Think of it
Accrued expenses are like a tab at a bar-you've consumed the drinks and owe the money, even though you haven't paid the bill yet.
Formula
Calculation
Accrued expense = Cost per period x Proportion of the period elapsed but unpaid
A company pays a weekly payroll of $50,000 for a five-day working week every Friday. The financial year ends on a Wednesday, so three working days have been worked but not yet paid. Accrued wages = $50,000 x 3/5 = $30,000. The company records a $30,000 wages expense and a $30,000 accrued liability, which is cleared when payroll runs on Friday.Case study
Seen in the real world
Greenfield Devices is a fictional electronics firm that, in this illustrative story, reported a strong profit of $620,000 in its first full year. A new finance manager reviewing the numbers noticed that no accruals had been recorded for the annual bonus, which staff would receive in February.
The bonus pool was estimated at $90,000, along with $25,000 of unpaid contractor fees for work completed in December. Together, $115,000 of costs belonged to the year just ended but had not been recorded because no cash had left the bank.
After booking the accruals, profit fell to $505,000. The directors were disappointed in the short term, but they avoided distributing dividends based on an inflated figure, and next year's results were not hit by a cost that belonged to the year before. The finance manager also introduced a month-end checklist so that accruals are reviewed every period.
Watch out
Common mistakes
- Waiting for the invoice before recording the cost. If the work or goods were received this period, the expense belongs to this period.
- Counting the cost twice, once as an accrual and again when the invoice is posted. Reverse the accrual or clear it against the invoice.
- Leaving accruals unchanged for months. They should be reviewed and cleared as invoices arrive.
Questions
People also ask
Are accrued expenses assets or liabilities?
They are liabilities, because they represent amounts the business owes. They are usually shown under current liabilities.
What is the difference between accrued expenses and prepaid expenses?
Accrued expenses are costs incurred but not yet paid, while prepaid expenses are costs paid in advance but not yet used. They are opposites in timing.
How accurate do accruals need to be?
They should be reasonable and supportable, usually based on contracts or past experience. Auditors expect consistent methods and prompt correction when actual amounts differ, and they will often test accruals against invoices that arrive after the period end.
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