Accrued expenses sound like a difficult, and time-consuming, accounting concept to comprehend. As the name suggests, accrued expenses are an accrual basis accounting concept. As such, many small business owners—who often operate on a cash basis—disregard accrued expenses.
This can be a costly mistake.
In this article, we will demystify accrued expenses. We will also clarify the difference between accrued expenses, prepaid expenses, and accounts payable: three concepts which are often confused for one another. And we’ll show you exactly why—even if your business is very small—you should consider the impact of accrued expenses on your financial statements.
What Are Accrued Expenses?
Accrued expenses are expenses you have incurred, but which you have not yet paid or been invoiced for.
Let’s clarify that with an example.
Your office manager notices the copier you lease is running low on toner. She calls the company who owns and services the machine on June 29 and asks them to send out a couple of new cartridges. The cartridges are delivered on June 30, but, as usual, no invoice accompanies the cartridges. Instead, your office manager hands the delivery ticket she signed over to your bookkeeper, so the bookkeeper has that documentation when the invoice arrives for the cartridges.
You have taken possession of (received) the toner cartridges, but you still don’t have an invoice on hand for them. This might not matter some months; however, we are now at the end of the quarter. Your bookkeeper needs to close out the books for the quarter and send them to your accountant for review and tax planning purposes. As you are all too painfully aware, toner cartridges for that copier aren’t cheap. Not recording the expense would overstate your net profit for the quarter by a significant amount.
Your bookkeeper decides to remedy this by making an entry into the books for the accrued expense. Based on the listed price of the cartridges, he makes the following journal entry dated 6/30:
Debit: Copy Expenses $1,200
Credit: Accrued Expenses Liability $1,200
This increases Copy Expenses on your profit and loss statement by $1,200, which in turn decreases your net profit by $1,200.
In order to not overstate expenses in the following quarter, your bookkeeper will post a reversing entry—crediting Copy Expenses and debiting Accrued Expenses Liability—dated 7/1. And, when the invoice for the cartridges finally arrives sometime after the July 4 holiday, the actual expense will be recorded in the books and the bill put into process for payment.
Why Should You Care About Accrued Expenses?
Although it’s true your cash position won’t be impacted by this accrued expenses entry immediately, it will in a few weeks’ time. The $1,200 recorded as an expense in the second quarter is $1,200 which won’t be included in your quarterly estimated tax calculation—a potential savings of hundreds of dollars in taxes due.
What If You’re a Cash Basis Taxpayer?
As we’ve mentioned before, taxes aren’t the only reason to keep accurate books. You should also be able to use your financial statements to make sound business decisions.
Even if you are a cash basis taxpayer—as most small businesses are—accruing expenses can still be a wise move, especially if they have a significant impact on your business decisions.
Here’s another example: Let’s say your business is installing swimming pools. And you’ve been installing a lot of swimming pools. So many, in fact, that you have had to increase your workforce… and everyone is still working overtime.
It’s the end of June, but your business is on a biweekly payroll schedule. Instead of payday being on June 30, it will fall on July 3.
Because your team has grown, and because they have been working so much overtime, you know it’s going to be a large payroll. You aren’t overly concerned, though, because you collect a deposit on each job before you start it. You know you’ll have enough cash to cover payroll.
Yours is a cash basis business, so your bookkeeper chooses not to accrue the payroll expenses you have incurred (because your team has already worked the hours) but not yet paid. You are over-the-moon excited when you see you have the largest net profit ever in the month of June.
This elation lasts until the beginning of August, when you get your P&L for July. Work has stayed steady, and you’ve offered permanent positions to some of the workers you hired on a temporary basis back in June. You’ve been confident about your profitability, so you are shocked—and maybe a little angry—when you see your net profit is actually negative for the month of July.
You ask your bookkeeper to recalculate the numbers, and everything checks out. However, your bookkeeper points out the expenses for the last two weeks’ of June’s payroll show up on the July P&L, because that is when it was paid. When you take that into consideration, your July net profit is no longer negative… but your June profitability is no longer nearly as high as you thought. In fact, compared to the previous year, June’s profitability was actually down, even after factoring in the extra work you’ve taken on.
Now you’re in a precarious position. You’ve thought your business was performing extremely well, and you’ve made commitments to some employees who have been going above and beyond to help you get your installations completed as promised. Now you find out your profitability has actually decreased as a result of higher payroll expenses.
Had your bookkeeper accrued the payroll expenses for June—by debiting Payroll Expenses and crediting Accrued Expenses Liability—you would have seen a month ago that your profitability had actually taken a hit due to your exponential business growth. You could then have made different business choices, such as:
- Increasing installation prices
- Adopting an installation schedule which didn’t require so much overtime
- Continuing to use your workforce of temporary workers, rather than hiring them on permanently.
And you could have made these changes a month ago, rather than having to react to a situation that is two months old and will continue for at least another month as you wrap up the installation season.
Accrued Expenses, Prepaid Expenses, and Accounts Payable: What’s the Difference?
Now that you’ve seen how accrued expenses can impact your business—both from a tax perspective and a managerial perspective—let’s clarify the difference between accrued expenses and two other terms which are often confused (and confusing.)
You already know accrued expenses are expenses you have incurred, but you have not yet paid them and you don’t have a bill or other expense documentation for them. Accrued expenses show up on your P&L as a debit, which decreases your net profit. On your balance sheet, they show up as a credit, which increases your liabilities (what your business owes to others.)
Accounts payable is very similar to accrued expenses in that it reflects a debit on your P&L for the expense and a credit on your balance sheet for the liability. The difference is, accounts payable indicates there is a bill or some other final documentation on file showing you owe a creditor for the product or service you have already received or consumed. You, or your bookkeeper, will use this documentation to back up the payment to the vendor.
Prepaid expenses, on the other hand, increase expenses on your P&L and increase assets on your balance sheet. They represent products or services you have not yet received but which you have already paid for. In this respect, they are the opposite of accrued expenses.
Insurance is a common prepaid expense. Let’s say you pay $3,600 for your business liability insurance in January. That $3,600 is your premium for the entire year, but you haven’t yet “consumed” the insurance for the year.
Your bookkeeper would record the premium payment as follows:
Debit: Prepaid Expenses Asset $3,600
Credit: Checking $3,600
This will decrease your checking account balance for the premium payment. Then, each month of the year, the expense will be recognized as follows:
Debit: Insurance Expense $300
Credit: Prepaid Expenses Asset $300
In this manner, the Prepaid Expenses Asset account decreases each month, until it’s $0 at the end of the year. Simultaneously, you are recognizing the expense each month of the year, rather than having the entire $3,600 impact your bottom line in January.
Accrued Expenses Demystified
Accrued expenses might sound like a difficult accounting concept, but they really are a relatively simple way of making sure your profit and loss statement reflects your business’s profitability more accurately. Ignoring the impact of accrued expenses can not only cause you to overpay your tax liability, but it can also lead you to make business decisions based on incomplete information.
Computerized accounting systems make it easy to record a reversing entry for accrued expenses at the same time as the entry for the expense. This makes the time required to recognize and reverse accrued expenses negligible in comparison to the impact the entries have on your financials.
Accrued expenses are similar to accounts payable, but not exactly the same. And accrued expenses are the opposite of prepaid expenses—another accounting concept you have likely encountered.
If you are still unsure about whether it is worthwhile to record your business’s accrued expenses, schedule a call with your bookkeeper or accountant. They will help you assess your business’s unique situation and determine whether accrued expenses will have a sizable impact on your financials.