What it means
Accrual accounting requires expenses to be recognised when they are incurred, not when they are paid. Many costs arrive in the ledger naturally through supplier invoices, but some are consumed before any invoice exists.
Staff work the last week of the month and are paid the following week. The electricity meter turns all month and the bill comes six weeks later.
A loan charges interest daily and collects it quarterly. At the period end, each of these is a real cost of the period and a real obligation, even though no document has arrived.
Accrued expenses capture them. The mechanics are simple.
At period end the accountant estimates the amount incurred and posts a debit to the relevant expense account and a credit to accrued expenses (or accrued liabilities). Early in the next period the entry is reversed, so that when the actual invoice arrives and is posted in the normal way there is no double counting.
If the estimate was wrong, the difference falls into the next period, which is acceptable as long as estimates are made in good faith and refined over time. Accrued expenses differ from accounts payable in one respect: payables are supported by an invoice, accruals are not.
The distinction matters for controls (accruals rely on estimates and need review) and for analysis (a growing accruals balance without a growing business may mean invoices are being delayed to flatter cash or that liabilities are being hidden). Auditors test accruals for completeness by looking at invoices received after the period end and asking whether they relate to the period just closed.
Regular, well-documented accruals are a sign of a mature finance function. A business that only records costs when invoices arrive will see profit lurch from month to month, and its year-end accounts will often be hit by a wave of costs belonging to the previous year.
In practice
Real-world examples.
Example
A restaurant accrues its staff's tips and service charge distribution for the last three days of the month, which is paid in the following week's payroll.
Example
A manufacturer accrues a warranty cost of 1.5% of sales each month based on historical claims, because the cost of repairing products sold this month will arrive over the next two years.
Example
A company accrues the year-end bonus pool of $250,000 monthly at $20,833 so that each month bears its share rather than December absorbing the whole cost.
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 incurred to date minus Amount already invoiced or paid
Worked example. A company closes its books on 31 March. It identifies the following unbilled costs:
- Staff worked 27 to 31 March (five days) and will be paid on 5 April. Weekly payroll is $35,000, so five working days = $35,000
- Electricity: the last bill covered the period to 15 February. Average usage is $2,400 a month, so 15 February to 31 March is 1.5 months = $3,600
- Loan interest: $400,000 at 9% a year, last paid on 31 December, so three months owed = $400,000 x 9% x 3/12 = $9,000
- Audit fee for the year just ended, to be invoiced in June: $15,000
- Sales commissions on March sales, to be paid in April: $8,200
Total accrued expenses at 31 March = $35,000 + $3,600 + $9,000 + $15,000 + $8,200 = $70,800
The entry: debit the five expense accounts for their respective amounts, credit accrued expenses $70,800. On 1 April the entry is reversed. When the payroll, electricity bill, interest, audit invoice and commissions are paid or posted in April, they clear against the reversal rather than hitting April's profit.Case study
Seen in the real world.
A logistics company with $30 million of revenue recorded costs only when invoices arrived. Its monthly management accounts showed profit swinging between $50,000 and $400,000 with no obvious pattern, and the owners had stopped trusting them. The problem became acute when the auditors found $1.1 million of invoices dated in the first six weeks of the new year that related to the old year: fuel, subcontracted haulage, vehicle repairs and December payroll.
The prior year's profit of $1.4 million fell to $300,000, the bank covenant was breached and the dividend had to be reversed. The company introduced a month-end accruals checklist covering fuel by vehicle mileage, subcontractor jobs completed but unbilled, payroll days, utilities and interest. Monthly profit settled into a consistent range, and the next year-end audit produced no accrual adjustments at all.
Watch out
Common mistakes.
- Accruing only for large items. Many small unbilled costs add up, and the audit will find them.
- Forgetting to reverse the accrual, so that the cost is recorded twice when the invoice arrives.
- Leaving old accruals on the balance sheet for years. Accruals that never clear should be investigated and released.
Questions
People also ask.
What is the difference between accrued expenses and accounts payable?
Accounts payable are invoiced and awaiting payment. Accrued expenses are incurred but not yet invoiced.
Are accrued expenses a debit or a credit?
The liability carries a credit balance. Recording an accrual debits the expense and credits accrued expenses.
How accurate does an accrual have to be?
A reasonable estimate based on available evidence is sufficient. Differences are trued up when the actual invoice arrives.
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