Proper Accounting for Accrued Expenses
Understanding Current Liabilities on Financial Statements
Jul 13, 2009
The main difference between cash and accrual accounting is that in accrual accounting, revenue and expense are incurred when they are earned, not when they are paid.
Revenue recognition is accomplished by setting up an accounts receivable. Expense recognition before actual payment is made requires the creation of a liability account.
Liability accounts can be current or long-term. Current liabilities are considered those that will be paid within one year. There are several distinctions within current liabilities, including accounts payable, accrued payroll and payroll taxes, current portions of long term debt and other accrued expenses.
Other Accrued Expenses
Other Accrued Expenses is a catch-all category for any liability that does not fit into a neat category on the balance sheet, such as accounts payable or payroll taxes. Expenses not on the books are said to be unaccrued.
Accounts payable is used for any item that has been invoiced but is not yet paid. If there is an item that has been incurred, but not invoiced, it should still be recognized through an accrued expense.
For instance, if management has authorized a consulting engagement, and the report has been delivered but the invoice has not been received, it would still be appropriate to accrue for this expense at the end of the month.
The entry should be:
Debit Consulting Expense
Credit Accrued Expense (or Other Current Liability)
When the invoice is received:
Debit Accrued Expense
Credit Accounts Payable
When the invoice is paid:
Debit Accounts Payable
Credit Cash
It can be seen that eventually for all transactions, Accrued Expense will eventually become zero. If it does not, there is a problem.
Importance of Accrued Expenses
The goal of every accountant is to present fairly the financial statements of the business. If there are expenses that have been occurred and they are not reflected at period end, the statements will not be accurate.
Management, outside investors and regulators depend on the accuracy of statements in order to make decisions. In the case above, if management is unaware that the consulting expense is not included, they may make incorrect decisions on how much money they have to spend on supplies, or maybe bonuses.
Finding Unaccrued Expenses
A good accountant will attempt to find unaccrued expenses to present an accurate financial picture.
- Compare expense line items against the budget. Items that are budgeted but not in actual expense may be the result of a missing invoice.
- Review a monthly trend of expenses. Many items are paid every month, and looking at last month, or better a history of several months, may trigger questions.
- A review of board minutes, or discussions with other management may help identify agreements or contracts that have been entered into but not expensed.
Finding unaccrued expenses is important saves embarrassment. There is nothing worse than going to the boss and admitting a large expense was missed last month.
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