Everything you need to know about Accrued Expenses
Today we’re going to talk about Accrued Expenses
This is my favorite question to ask in an interview
Because there is so much to unpack
What are Accrued Expenses?
Technically speaking, an accrued expense is when an expense has been incurred, but not yet paid
This is especially relevant in accrual accounting, where income gets recognized only once it’s earned, and expenses recognized only once they are incurred
How do Accrued Expenses differ from Accounts Payable?
Under the definition above, they would be the same
Accounts Payable is an “Accrued Expense”…
That is…an expense that has been recorded but not yet paid
So why distinguish between Accrued Expenses and Accounts Payable?
Most people use the term Accrued Expenses on the balance sheet to reference an expense that has been incurred, but a bill hasn’t been received yet
The Accrued Expense is oftentimes an estimate of what the invoice amount will be once it comes in
Once the bill actually comes in, it would be reflected in your Accounts Payable
Can we go through an example?
Let’s say you got on the phone with a lawyer this month for a few hours
Your lawyer chargers you net 30 (you have 30 days to pay)
If you received the bill, it would go under Accounts Payable until you pay
If you didn’t receive the bill, it would go under Accrued Expenses for the amount that you estimate the bill will be for
So what happens to the Accrued Expense once the actual bill comes in?
You would do 2 things:
1. Reverse the accrual. That means you would show a negative expense on the P&L , and a reduction in Accrued Expenses balance
2. Record the bill in the current period as if you never recorded the accrual
The increase + decrease in the expense will cancel each other out, and you would swap the balance of your accrued expenses with your accounts payable
Accrued Expenses are a popular Liability, because it is common to not receive bills from vendors by the time you are looking to close out the month.
Technically, any expense that is incurred but not yet paid under the accrual basis of Accounting is an accrued expense, but most often when you hear the term, it will relate to an estimate of an expense that you’ve already consumed, but have yet to receive the bill
The process involves the following:
Booking the expense on your profit & loss (via a debit), and increasing the accrual on your balance sheet
In the following month in which the bill is received, you’ll then book a new expense, and this time increase your accounts payable (or reduce your cash)
You will then reverse the accrual, resulting in a net 0 accrued expense balance, and only 1 instance of the expense on your Profit & Loss