In the world of accounting, there is a rhythm of sorts that has to be followed in order to account for financials properly. Part of this rhythm includes recording expenses in one of two ways (cash or accrual). A popular choice is through accrued expenses, in which you account for a future charge before it is actually invoiced.
While not everyone chooses to perform accounting this way, it’s important to understand the structure of accrual accounting as well as the types and how to record them.
Accrued expenses are expenses that have been accounted for but have not yet been billed. For instance, you’re likely using electricity to power some part of your business. Every month you account for an electric bill before you know exactly how much energy is being used. This is a form of accrual accounting.
Expenses are accrued to have a better understanding of financials through a holistic view of what’s actually due. This practice differs from the other form of accounting, cash basis accounting. Cash basis only accounts for expenses that have been invoiced and paid for. This can potentially leave expenses unaccounted for if the bill has yet to arrive.
Accrued expenses fall into three main categories that can be accrued due to the nature of the expense and when it’s incurred. These include salaries, interest, and miscellaneous expenses like utilities and taxes.
Salaries are a representation of the income paid out to employees who have a set pay per period, regardless of the amount of time they worked.
During the accounting cycle, an accounting close occurs during a pay period, which can throw off the records. For example, an accounting period can close on the 31st of the month, but the 31st lands on a Tuesday in the middle of a workweek. Since the pay period runs from Monday to Sunday, this interrupts the pay cycle. In order to account for the expense of wages that will be paid out, the company accrues them.
Oftentimes companies will take out loans to buy resources needed to sustain or grow the company. These loans come with interest, and interest isn’t fully paid until the loan has been repaid. To account for this expense, the company opts to accrue the interest amount at the end of the accounting period for the amount of interest the loan has accumulated.
Since some expenses are incurred before the invoice is due, they are also known as accrued expenses. These include expenses like utilities or taxes.
Accrued expenses, also known as accrued liabilities, can be either a credit or a debit depending on the situation. There are two instances where an accrued expense can be one or the other. For further explanation, let’s look at how they are recorded.
Determining whether an accrued expense is debit vs. credit all has to do with when it is recorded. Whenever you first accrue the expense it is recorded as a credit, and once you pay the expense it then gets recorded as a debit.
Instance #1 (debit): Whenever you accrue an expense you will record it as credit, which in turn debits the expense account. By debiting the expense account, you increase the expenses on the income statement and your liabilities increase on the balance sheet. For example:
Instance #2 (credit): When you go to pay the expense, usually at the beginning of the next accounting period, you now switch the entries. You credit back the assets and debit the liabilities. This removes the liability from the balance sheet and increases the cash on the income statement.
Let’s say a construction company receives hauling services from a subcontractor throughout the month of March. However, the subcontractor doesn’t bill until April. To account for the payout, the field engineer will track progress and work performed by the subcontractor, keeping a record of all expenses that will come to fruition in April.
On March 31, the field engineer confirms with the subcontractor that the numbers he’s tracked are correct. He does this to avoid any discrepancies between what he recorded and what the subcontractor has actually performed (so the billing amount and the accrual amount are the same).
Once the field engineer completes the accrual estimate, the accounting department makes an adjusting journal entry to debit the subcontractor expenses on the income statement and add a credit to the accounts payable on the balance sheet. Once the bill is received from the subcontractor and the debt has been paid, the accounts payable account is debited and the cash account is credited.
Accrued expenses occur only when work has been performed but no bill has been received. An accrual expense is recorded to offset the bill that is coming for next month but has occurred in the previous month. Accrued expenses are sometimes confused with accounts payable and cash accounting, but they’re not the same. Let’s take a look at the differences between the three.
Cash basis accounting is another method of accounting for revenue and expenses. It involves paying and recording an expense only when a bill has been received.
Note: Companies should not switch back and forth between accounting methods. Changing your accounting method can make for a messy audit when it comes to checking your books.
Accounts payable is not an accounting practice—it’s part of an accounting process for accrual accounting methods. Accounts payable is a record of all the outstanding accounts that are due to be paid by the company.
Since cash basis accounting only recognizes expenses when the invoice has been received, it has no use for accounts payable or accounts receivable.
Both cash basis and accrual accounting are legally recognized under GAAP (Generally Accepted Accounting Principles). It’s up to you to choose which method is best for your company. For some industries, accrual accounting is more popular than others, and vice versa.
Whichever practice you decide to implement as part of your regular accounting process, you may find that you need some extra help. With experienced CPAs and bookkeepers, QuickBooks accounting software offers expert help to assist you in keeping track of your accruals or your cash expenses so each close period is more streamlined.
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