Introduction to Accrued Expenses

Introduction to Accrued Expenses

Accrued expenses refer to the expenditures that a company has incurred, but it has not documented any information about it yet. Instead of documenting the expenditure, the company creates a journal entry to record the accrued expense (Also see The Rules for the Recording of Journal Entries). At the same time, that entry acts as an offsetting liability, and usually, the companies would categorise it as a current liability in its balance sheet.

Without the journal entry, you will not be able to find the expense in the financial statements of your business within the period incurred. As a result, the reported profits of your company will be very high in that period. In a nutshell, you need to record the accrued expenses as this makes your financial statements more accurate. This is because if you do so, the expenses and their associated revenue will be aligned more closely (Also see The Concept of Revenue Recognition).

The opposite of accrued expense is the prepaid expense as you pay the liability before you consume the underlying asset or services. As a result, initially, you will see the prepaid expense (Also see Accounting for Prepayments) is recorded as an asset in your company’s balance sheet.

Let us look at how would the accounting firm in Johor Bahru handle the transactions related to accrued expenses in actual practice:

Generally, the companies will accrue the below expenses:

  • Wages incurred that they have not made the payment to their employees
  • Services received that they have not received the supplier invoice
  • Goods sold or goods received and consumed that they have not received the supplier invoice
  • Loans or interests that they have not received the lender invoice
  • Taxes incurred that they have not received the invoice from the government department (Also see Types of Audit – Tax Audit)

For example, when a company has received office supplies from its supplier at the end of the month, but it has not received the supplier invoice when it closes its books for that month, then it is an accrued expense. If the company wants to record the expense correctly in the month they received the office supplies; then in the supplies expense account, the accountant should record an expense by debiting the amount it expects the supplier will bill it and crediting the amount to the accrued expenses liability account. Hence, if the office supplies worth RM1,500, then the entry would be:

  • Debit RM1,500 to office supplies expense account
  • Credit RM1,500 to an accrued expenses liability account

Typically, the accountant will create the journal entry as a reversing entry that works automatically. Thus, the accounting software will create an offsetting entry automatically when the next month begins. So, when the company receives the supplier invoice later on, it will cancel out the reversing entry.

By using the example above, in the next month, the entry of RM1,500 would reverse, which means the entry would be:

  • Debit RM1,500 to an accrued expense liability account
  • Credit RM1,500 to the office supplies expense account

Then, the company will receive the RM1,500 supplier invoice. What it will do is to record it usually as accounts payable in its accounting software. Hence this results in the entry below:

  • Debit RM1,500 to office supplies expense account
  • Credit RM1,500 to accounts payable account.

Therefore, in the next month, there would not be any new expense recognition as the company has transferred the liability for payment to its accounts payable account.

In the real situation, the company will only be able to estimate the sum of an expense accrual account. Thus, there is a possibility where the estimated amount would be different from that of the supplier invoice they receive later. As a result, once the accountant has reversed the journal entry and netted the supplier invoice’s amount against each other, usually there would be a small amount of negative expense recognition or an extra amount of expenses in the next month.

When such situations happen in real life, the company will not accrue immaterial expenses as it has to complete a lot of work to create and record the journal entries related to that transaction. Also, the process of closing the books of accounts will be slower if the company has a lot of accrued expense journal entries (Also see Understanding Year-end Adjustments).

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