As a small business owner, you want to get a true picture of your company’s resources and financial responsibilities. This means you should recognize income as soon as you earn it and expenses as you incur them.
If your company receives goods or services from suppliers and you pay for them in the following month or accounting period, and you recognize these accrued expenses before making the actual payments.
What Are Accrued Expenses?
Accrued expenses are the expenses your company incurs before you pay for them. Typically, you note these expenses as current liabilities, but you pay them in the next financial period. You need to log these expenses in your firm’s accounting books, such as on its balance sheet, because you must pay them in the future.
But why should you record accrued expenses before making the necessary payments? As a responsible business owner, you want your expenses to closely align with your revenues to increase accuracy in your firm’s financial statements.
Without making the necessary journal entries, your profits may be too high and not reflect the actual income you make in a particular financial period. Besides, if you use accrual accounting for tax purposes, the government requires you to disclose these types of accrued expenses.
Examples of Accrued Expenses
Typical examples of expense accruals include salaries payable, utilities, and taxes you incur, for which the government has yet to issue an invoice. If you run a startup or small business, you might need to take out a loan to fund your day-to-day operations. You must to pay the loan and the accumulated interest at some future date.
In this case, the interest serves as the accrued expense, and you recognize it during the current accounting period.
As another example of an accrued expense, imagine your company receives raw materials from a supplier near the end of the month, and you close your books before you receive an invoice from the supplier. In this case, you enter an accrued expense liability when you receive the raw materials and a materials expense when you actually pay.
For most small-business owners and independent contractors, the Canada Revenue Agency requires you to report accruals when you file your taxes, so it’s important to understand how to handle them.
Because you often record accrued expenses or income at a different time than when payment is exchanged, accrual-based accounting requires you to make two entries for each event.
How to Record Accruals
When you recognize income, you enter the accrual under your income account as well as an asset account, such as accounts receivable. When you recognize an expense, you enter the accrual under your expense account as well as a liability account, such as accounts payable.
Then, when the payment exchanges hands, you can offset the accrual in your asset or liability account and then debit or credit your cash account.
While this requires additional steps compared to cash-based accounting, it’s much easier to record each event properly than wait for the end of the year to convert your cash-based records to comply with CRA accrual-based accounting requirements for tax purposes.
Recognizing expenses even before you pay for them ensures your books stay up to date with your company’s current resources and financial obligations. With QuickBooks Online, you can organize your business finances and stay ready for tax time. Try it free for 30 days.