Everything You Need to Know About Accrued Expenses

Almost all organisations make a provision for accrued expenses on the balance sheet, which are scheduled for payments within the financial year. Despite this, these are written down in the organisation's balance sheet. The word 'accrued' means that which gets accumulated over a certain period of time. For instance, you may be the recipient of some products and services but have not been billed for the same, and you pay for them after you receive an invoice for the same. Such expenditures are accrued expenses. They serve as indicators of the probable liabilities that an organisation will incur at a future date. This gives the organisation clarity on its revenue status.

Interestingly, no invoices are received for these expenses, but they are still reflected in the balance sheet as futuristic expenses. They continue to appear on the balance sheet until incurred. Once incurred, a reversal entry is made for them, after which they do not appear on the balance sheet.

Did you know?

That most organisations consider employee bonuses and even salaries as accrued expenses!

What Are Accrued Expenses?

Every commercial business functions on the facility of loans and deferred payments. Accrued expenses are one such type of expenditure that businesses resort to. These are better known as current liabilities, as the payments are settled within twelve months. These expenses are reflected in the organisation's balance sheet as pending payments that have not yet been billed. If the payments are made after the year expires, such expenditures are no longer considered current liabilities but long-term liabilities. You accumulate a liability in one FY and pay the expenditure incurred in another FY. These accumulated expenses are liabilities at the end of that specific accounting timeframe. You need to reverse these liabilities when the payments are made in the next accounting year. Thus, what was recorded earlier as debts will now reflect expenditures incurred.

Also Read: What are Direct and Indirect Expenses?

Cash Basis Accounting vs Accrual Accounting

This type of accounting distinguishes all expenditures and incomes based on cash. Accrual accounting distinguishes income that is earned and expenditures that are billed later.

Cash Basis Accounting

There are many small-scale commercial enterprises that choose to utilise this basis of accounting for various reasons, namely:

• The maintenance of cash transactions is easier.
• This type of accounting indicates the details of transactions, e.g., the timing of the transaction, whether it is an inflow or an outflow. You don't have to constantly monitor every transaction in real-time.
• This accounting gives a clear understanding of the total amount of cash your business has at a specific time.
• Your bank balance is reflected accurately.
• You get an understanding of the total amount of revenue available to you.

Accrual Accounting

In this type of accounting, all your expenditures and revenues are recorded whether you are the recipient of or have made payments.

• Revenues are recorded on the completion of every business project and not when you receive payment.
• This system gives details about expenditures as well as incomes for specific timeframes.
• You get clarity on all the liabilities because it considers both expenditures made in advance and those accumulated or accrued.
• It gives a detailed understanding of all transactions for every distinct accounting timeframe, whether it has taken place in the past, present, or is considered for the future.
• It effectively determines the financial standing of an organisation and helps in forecasting the same for the future as well
• To sum it up, many businesses maintain their books of accounts (book-keeping) on a cash-basis accounting and file their respective taxes based on accrual accounting.

Why Are Accrued Expenses Important?

The importance of accrued expenses lies in the fact that they monitor the financial status of an organisation in a very organised and accurate manner. They help to adjust the money that has been earned with the expenditures, even if there has been no cash transaction. Accrued expenses depict the payment obligations of an organisation that has to be fulfilled by it in the near future. As a result, they are reflected as current liabilities on the organisation's balance sheet. These are important for a host of reasons, namely:

• The accounting statements that detail all the finances are more accurate
• This accounting considers accounts payable and accounts receivables you with all the details of all the transactions for every distinct timeframe
• They give you an insight into the present monetary status of the organisation
• They also furnish you with details on what the financial activity of the organisation is likely to be in the future.
• The chances of procuring more credit or loans are better because of the authentic reflection of the financial health of your business
• As the founder or one of the founders of the business, you get a detailed understanding of the profitability margins of the organisation, the sources of profit as well as the expenditure outflows
• These expenses are very transparent. They help investors, vendors, finance creditors, and any other authority desirous of evaluating your business's financial standing at any time.

Examples of accrued expenses

All products and services made use of without receipt of the bills are considered accrued expenses.

Given below are some of the most common examples of accrued expenses:

• Utilities – Usage of electricity, garbage collection, water, housekeeping, and internal hygiene of the premises for which payment has to be made.
• Salaries or Payroll – An organisation owes its employees
• Interest – Non-payment of accumulated interest, which is added to any financial obligation the business avails of, like bonds and loans.
• Benefits to employees – Vacation leave that has not been utilised, payments for sick leave – all benefits that employees are due and will be made at a future date.
• Taxes – For which you will receive invoices.

Also Read: Why is Maintaining Administrative Expenses Important?

How to Record Accrued Expenses?

Journal entries for adjusting accrued expenses involve debiting an asset account, and when the payment is made, the same is reversed.

Given below is an example of how you can adjust journal entries for accrued expenses:

ABC Technologies agrees to create a tracking software for the Road Traffic Police Department (RTPD) for a sum of ₹ 80,000 in 12 months. ABC Technologies has to furnish RTPD with the first module in 6 months as per the agreement details. The total value of this is ₹ 40,000. The second and final module will be delivered at the end of the 12th month, bringing an end to the contract. Therefore, the billing will be towards the end of the 12th month for the amount of ₹ 80,000.

When the first module is delivered, ABC Technologies will have to make an accrued revenue journal entry.

Once ABC Technologies fulfils the delivery of the 2nd module of the software, it bills RTPD for the amount of ₹ 80,000. ABC Technologies will now make a journal entry to reverse the amount accrued initially. It will also make another entry for the total amount of the invoice i.e. ₹ 80,000.

All the debit balances directly connected with the accrued income are recorded on the balance sheet. The change in revenues is reflected in the income statement of the organisation.

Conclusion

The details of this article explain in very simple terms the accrued expenses meaning and their importance. The article also is informative with examples of accrued expenses and how they play a crucial role in understanding the financial health of an organisation. Accrued expenses on the balance sheet are reflected in current liabilities because they have to be fulfilled within a time span of 12 months.

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