Tracking accrued expenses reduces the chances of surprise expenses and gives you a more accurate picture of your company’s overall performance.
In this guide, we delve into the intricacies of accrued expenses. First, we’ll refresh your memory on what they are, why they’re important and where they fit into corporate accounting, and then share strategies for building more advanced techniques like automation into your workflow. Let’s dive in.
Accrued expenses are financial obligations that a company incurs but hasn’t paid for during a reporting period.
Think of it like scheduling a mortgage payment for the end of the month rather than right when you get your bill. By the end of the month, you’ll have received your paycheck and have ample cash to pay your mortgage company.
Just like you, companies are waiting to be paid for their products and services. Putting an expense on a company credit card or only paying contractors on a Net 30 basis gives them some breathing room, allowing them to pay for expenses after their money comes in.
Accounting for accrued expenses as soon as they come in ensures that bills are paid on time and that the company has a true picture of the cash they have to work with. This is critical when budgeting for major expenses like new facilities, new hires, or other big shifts in company strategy — you don’t want to overshoot. And you also don’t want to risk publishing accurate financial reports, which can result in hefty IRS fines and jeopardize shareholder trust.
Accrued expenses can be anything from wages and salaries to loan interest to property tax. Here are some examples of the most common accrued expenses:
In accrual-based accounting, expenses are recorded as soon as they are incurred — even if they will not be paid for until future periods. Accountants recognize accrued expenses by creating a journal entry to debit an expense account and credit an accrued account.
Say a large biotech company is expecting a big utility bill for their main office — $175,000 — at the end of the month. Its Utility account needs to be debited to reflect the $175,000 cost on the company’s income statement, and the Accrued Utilities account needs to acknowledge the obligation to pay the employees.
That journal entry would look something like this:
Debit: Utility Expense $175,000
Credit: Accrued Utilities $175,000
Once the expense is paid, it will be removed from the expense account and the cash account on the balance sheet.
Accrued expenses and accounts payable are both liabilities, but they differ in timing and nature. Like accrued expenses, accounts payable represent goods or services a company has received and not yet paid for. But unlike accrued expenses, accounts payable are tied to an invoice and must be settled within the terms of that invoice.
Accrued expenses, on the other hand, don’t have to be tied to an invoice — they can be for other known expenses, like wages, utilities, or taxes. Tracking a broader spectrum of costs that a company knows they’ll eventually have to pay leads to a more comprehensive and accurate reflection of a company’s financial standing.
Deferred expenses, also known as deferred charges, are prepayments for goods or services that do not take place within the year — like certain long-term investments. Because the benefits of these goods and services aren’t realized right away, deferred expenses fall into the long-term asset category, and accountants deduct an equal portion of the costs for every reporting period that the goods or services are delivered.
Since accrued expenses are costs that have not been paid for, they are considered liabilities until they are paid.
Because accrued expenses don’t always come with an invoice, some expenses will have a known amount, and some won’t. These are called fixed and determinable accrued expenses, respectively.
More specifically, fixed accrued expenses are costs that remain constant and do not fluctuate with changes in business activity — they are consistent and predictable over time. Some examples are wages, monthly rent, and subscription fees.
Determinable accrued expenses are those for which the exact amount and timing of payment aren’t set but are at least estimable. For example, you can likely forecast your taxes, interest, and insurance premiums based on known rates, previous history, or other contractual terms.
Categorizing accrued expenses properly helps companies anticipate and plan for various accrued expenses more precisely, knowing that determinable expenses may be subject to change.
In accrual accounting, you can only record revenue when all goods and services have been provided. But, as we described earlier, some customers opt to prepay for future goods and services. For the company being paid, the chunk of cash they receive upfront is called “unearned” or “deferred” revenue.
This happens a lot in B2B SaaS, where businesses pay for the use of software for a year or sometimes longer. In those cases, SaaS companies can’t just record all that revenue at once — they have to note their obligation to deliver it over time as a liability. Over the course of the contract, the unearned revenue liability converts into current revenue, shown on the company’s income statement.
Here’s an example:
Software company XYZ closes a 5-year $150,000 contract, and the customer pays that amount as soon as the deal is signed.
The accounting team at XYZ will then increase the unearned revenue account by $150,000 and decrease cash by $150,000. Every month, the team will post a credit to the revenue account (increasing it) and debit the unearned revenue account (decreasing it).
As we know, accrued expenses are costs that have been incurred but not yet paid. If revenue wasn’t tracked at the time goods and services were delivered, it would appear that a company has more revenue to cover its expenses than it actually does, causing major problems down the line.
GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) are two different accounting standards. Accrued expenses are treated similarly under both frameworks, but there is some nuance in their terminology and presentation.
Under GAAP, accrued expenses are recognized based on the matching principle — as soon as an expense is incurred, the appropriate expense account is debited, and an accrued liability account is credited. The more conservative framework of the two, GAAP suggests that expenses without a concrete invoice should be on the higher end.
IFRS also leverages the matching principle but takes a less conservative approach, encouraging companies to reflect the economic reality of transactions. In other words, companies should (1) make reasonable estimates based on the information they have available, with notes to explain their approach to shareholders, and (2) reassess those estimates at each reporting date.
Accrued expenses are a crucial piece of the accounting puzzle, helping businesses uphold GAAP standards and drive accurate decision-making. But recording every expense manually is a tedious job that takes valuable time away from other strategic work your accountants could be doing.
Software like Gappify automates vendor and PO owner expense requests, posts SOX-compliant transactions, and compares current month accruals with prior period actuals in a single cloud-based platform, creating a holistic view of your spending — without the hassle. To see how Gappify can help you automate and audit-proof your accruals first-hand, book a demo today.
Accrued expenses aren’t directly featured in the operating activities section of a cash flow statement but have definite implications on a company’s cash flow.
A cash flow statement primarily focuses on actual cash transactions. And because accrued expenses involve recognizing liabilities before cash payments, they don’t appear in the operating activities. That said, an increase in accrued expenses signifies an impending cash outflow in the future, which will impact cash flow statements in subsequent periods.
Accrued expenses aren’t expense accounts — they are recorded as a liability on the balance sheet and transition to an expense account when a company pays what they owe. The expense account is shown on the income statement to portray the financial impact of the incurred expense accurately.
Yes, accrued expenses are represented as current liabilities on a company’s balance sheet. Even though they are expected to be settled within a near-term operating cycle, having them on the balance sheet helps businesses track and report their true liquidity.
Prepaid expenses are advance payments for goods or services, like insurance premiums or subscriptions. Companies often prepay because they are offered a discount for doing so. These expenses are recorded on a balance sheet as a current asset but are gradually recognized as expenses as they are consumed.
For instance, say a business pays its annual insurance premium of $15,000 in January for the first half of the year’s coverage. Every month, the prepaid expense account for insurance will decrease by $2,500 (a sixth of the cost) on the company’s balance sheet, and the income sheet will reflect a corresponding increase of $2,500.
Accrued expenses are essentially the opposite of prepaid expenses — they are used, tracked, and then paid for.
So, the crux of the difference between prepaid and accrued expenses is in the sequence of recognition: prepaid expenses are considered assets before becoming expenses, and accrued expenses are considered liabilities before they transition to expenses.
The IRS established the 8.5-month rule (Sec. 461(h)(3)) to offer companies a tax advantage for certain prepaid expenses. According to the rule, an expense is incurred and deductible in the tax year if it meets the “all-events test” and the economic performance in question occurs within 8½ months after the close of the tax year.
The all-events test is threefold:
If these conditions aren’t met, businesses can’t deduct an accrued expense for the tax year.
The accrued expenses turnover ratio is a measure of how efficiently a company pays off its debts. You can calculate your accrued expenses turnover ratio by dividing net sales by the average accrued liabilities during a specific time period.
The more sales you make and the fewer expenses you incur, the easier it will be to pay bills on time, and the higher your ratio will be. A higher ratio is a positive indicator for investors, creditors, and financial analysts — it shows a company can meet short-term financial obligations promptly.
Yes, accrued expenses are incorporated in working capital. For context, working capital is a measure of a company’s short-term liquidity and operational efficiency. It’s calculated by subtracting liabilities from assets on a company’s balance sheet. And because most accrued expenses are considered current liabilities (they need to be settled within a year), they are inherently a key component of that calculation.
Gappify, founded in 2016, is a cloud-based provider of accrual automation solutions for mid-market and enterprise accounting teams. The company is headquartered in New York City, with offices in Berkeley, California, Washington DC, and Manila, Philippines.
Its team consists of accountants and CPA’s from Big Four accounting firms and software innovators. Gappify is also supported by strategic advisors from some of the world’s most recognized technology companies and is affiliated with the top companies & accounting organizations.