Businesses of all types rely on good accounting practices in order to run smoothly and ensure that their operation is making a profit. The methodologies may differ from company to company, but they all fall into one of two general categories: cash basis or accrual basis. Most individuals and smaller businesses use the cash method for ease of use, but larger and more complex businesses use the accrual method of accounting. One aspect of accrual accounting that can be somewhat confusing is related to accrued expenses.
To really make sense of how accrued expenses fit into a business’s financial reporting, it’s crucial to understand the difference between the two methods. The fundamental difference between the two is related to when revenue and expenses are recognized. This is an important distinction, both in terms of keeping accurate books and staying in compliance with SEC regulations. Public companies, for example, are required by the Generally Accepted Accounting Principles (GAAP) to use the accrual method in large part because of revenue and expense recognition.
Cash basis accounting, as noted earlier, is typically used by small businesses or for tracking personal finances. As the name implies, this method is all about cash flow and tracking money going in and money going out. Revenue is recognized in the cash basis method when the money is actually received, either in currency or a credit to a deposit account. Likewise, expenses are only recognized when money is paid out. The advantage of cash accounting is its simplicity, but the disadvantage is that the focus on cash flow may overstate the company’s financial health by omitting payable accounts.
Under the accrual basis of accounting, by contrast, revenue is recognized after it is earned; in other words, it is recognized after a good or service is delivered to a customer with the expectation of being paid at a later date. Likewise, expenses are recognized on financial statements after they are incurred: after a transaction but often before any money is paid out. Understandably, this method of accounting is more complicated, but it also paints a more accurate picture of a company’s finances because it incorporates accounts payable and accounts receivable.
Accrued expenses are a component of accrual basis accounting, and they represent expenses that are recognized before they have actually been paid. It is because accrued expenses are considered current liabilities on the balance sheet (because they are an obligation to make cash payments in the future) that they are sometimes also referred to as accrued liabilities. Accrued expenses can sometimes be estimates of what will eventually be paid out as well. The following are some examples of accrued expenses:
A somewhat related term is a prepaid expense. Unlike an accrued expense, a prepaid expense is paid in advance for goods or services that will eventually be received in the future. Prepaid expenses are actually recorded as assets on the balance sheet at first; over time, the value of these assets is expensed and is noted on the income statement. Whereas accrued expenses are always recognized in the period in which they are incurred, the value of prepaid expenses can be measured over multiple accounting periods.
When accountants and bookkeepers reconcile the general ledger, they usually treat an accrued expense journal entry as a debit to an expense account and a credit to an accrued liabilities account; this is how both expenses and liabilities are increased. An accrued liability is considered a reversing entry (a kind of adjusting journal entry) that is temporarily used to adjust the books between different accounting periods.
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