What are Accrued Expenses?
A typical year in a business cycle constitutes several different expenses incurred evenly or unevenly during the course of the business. Mostly, companies do not always pay expenses in an upfront manner.
These companies pay these expenses later to get some leverage that might help them keep cash in hand intact. These expenses that are utilized and not yet paid for are defined as accrued expenses.
In simple terms, accrued expenses are simply those expenses the utility (or the service) from which has been derived, and the payment for these particular expenses has not yet been made.
It is essential to consider that following the matching principle (and the accrual basis of accounting), these expenses are still supposed to be shown as expenses in the financial statements (both the Income Statement and the Balance Sheet). This is because they are related to the current year in the company, and hence, they should be declared as expenses for the current year.
Since accrued expenses are obligations that need to be paid by the company, they are classified as liabilities by the company. Mostly, they are supposed to be settled within 12 months by the company, and therefore, they are classified as Current Liabilities.
As mentioned earlier, Accrued Expenses are payments that need to be made by the organization to settle for goods and services they have already utilized. Therefore, they are classified as liabilities.
Since it is short-term debt, they are categorized as Current Liabilities in the Balance Sheet. The main reason behind the classification lies in the fact that they are supposed to be settled in less than 12 months.
It is also essential for accrued expenses to be classified as Current Liabilities for the current year because of the accrual basis of accounting. This implies that expenses for a given period should be matched with the revenues of the given period. Therefore, it is of tantamount importance to include them as expenses, regardless of the payment status of the expense itself.
On the other hand, if companies utilize the cash basis of accounting, there are no accrued expenses in that particular case. Only those expenses are recorded that are actually paid for.
However, this is not the correct approach. Companies follow the accrual basis of accounting to determine the actual volume of profits earned in a given year by comparing the revenue earned with the expenses in the particular year.
The concept of accrued expenses follows the logic that all expenses that have been incurred by the company but are yet to be paid for are classified as accrued expenses. This means that once the financial year has ended for the company, the company must record all the expenses relevant for the current year.
However, any future expenses that are not yet realized are not supposed to be recorded as Accrued Expenses. They are only supposed to be recorded in the financial statements once they are incurred, and they need to be settled.
It is also important to note that any foreseeable or confirmed expenses are also not supposed to be included as Accrued Expenses because they are not relevant to the current year. Only that portion of the expense is supposed to be recorded as an Accrued Expense, which has already passed, and the organization has already utilized the service.
Given the nature of the accrued expenses, they are recorded as Current Liabilities in the Balance Sheet. They are only recognized at year-end when accountants begin to calculate the number of expenses that have occurred in the given year and the appropriate payable amount for those accounts. Furthermore, it is important to note that they are recognized as Current Liabilities as part of the double-entry system in accounting.
In the case of expenses that are occurred in the company and are paid upfront in cash, the following journal entry is made:
However, in the case of accrued expenses, where organizations settle the dues at a later date, the following journal entry is made:
Therefore, a liability is created to reflect the company’s obligation about the settlement that needs to be made instead of the expenses that have been utilized over the year. If this amount is settled before the year-end, no amount is going to be declared as a Current Liability in the Balance Sheet, as shown below:
However, suppose the amount stays unsettled at the end of the financial year. In that case, it will be recorded as Accrued Expenses under the Balance Sheet as a Current Liability.
The purpose and treatment of Accrued Expenses are further explained in the example given below:
Henry Co. has leased premises to conduct their factory operations. The yearly rent for the premises amounts to $2400. At the beginning of 2019, they had $600 outstanding that had to be paid to the landlord instead of the rent for the year 2018. During the year 2019, Henry Co. paid an amount of $2,500 as rent to the landlord. What are the accrued expenses for rent for the current year?
In the example mentioned above, it can be seen that the monthly rent for the premises rented by Henry Co. amounts to $200. During the year, the rental expense amounted to $2,400.
This implies that the total payable amount by Henry Co. was $3,000 ($2,400 for the current year + $600 outstanding rent). Out of this, they paid an amount of $2,500. This implies that $500 was still outstanding as a rental expense for the current year.
In other words, this implies that there is an Accrued Rent of $500, which is relevant to the Current Year that needs to be paid by Henry Co. It is also important to understand the fact that this outstanding balance needs to be treated as a Current Liability because it relates to the current financial year. Subsequently, the amount expensed in the Income Statement would correspond to the Rent charges for the current year. The expensed amount would not change with the payment being made for rent.
This implies that the amount for Rental Charge for 2019 would be $2,400 in the company’s income statement.
Are Accrued Expenses the same as Accounts Payable?
Accounts Payable are the amounts that the company needs to pay to settle the accounts of the company’s creditors. During the ordinary course of business, an organization might procure goods and services on credit.
The amount that needs to be paid to settle the bills for these goods and services are classified as Accounts Payable. These are the goods and services that the company has procured to resell. Therefore, Accounts Payables only comprise supplier account balances.
Even though both Accounts Payable and Accrued Expenses are classified as Current Liabilities, they serve different purposes. Accounts Payable reflects the amount that needs to be paid to the creditors, whereas Accrued Expenses are other miscellaneous expenses that need to be settled by the company.
Examples of Accrued Expenses include accrued rent and accrued utilities. Both these accounts cannot be clubbed together because they represent different types of obligations for the company.