EBITDA and Other Scary Words: Scary Words No.9 - Accrued Expenses
In our last installment, we learned all about Accounts Payable. We saw that accounts payable is a current liability. We also saw that it is usually one of the first liabilities listed on your balance sheet. Today, we explore a related topic: Accrued Expenses.
Here’s a Standard Transaction/Expense Process:
- Your vendors grant you a credit
- You purchase goods for your business
- You receive an invoice
- There is time to make payment for the purchases of these goods.
It is likely that you’ll also grant credit to your customers. This means you will need the extra time offered through vendor credit. Remember, you should time future cash flows from receivables with future vendor payments.
But, what happens when we incur costs, but we did not receive the invoice from our vendor?
Does this mean that you don’t have to record the liability? (yeah, wishful thinking)
In truth, you actually do incur the costs associated with these goods or services. So how do you account for these items? Well, here’s your answer —
Scary Word No. 9: Accrued Expenses.
Accrued expenses, sometimes called accrued liabilities, are costs incurred by the business without an invoice. Transactions like these do not record right away.
Let’s take a look at a very common scenario: You order your weekly supply of beer (remember, you own a bar), and included in the shipment is the invoice from the vendor. You take the invoice and give it to your accounts payable clerk. The clerk enters information from the invoice into your accounts payable system with a due date based on the payment terms granted to you by the vendor.
Just like that, a transaction records for a cost that is incurred.
This is a clear example of accounts payable at work. But, if we drill down a bit further, another transaction occurs here…one for which you do not have an invoice.
What could that be?
Well, your accounts payable clerk receives wages, correct? He or she has been working all week, so you presently incur payroll costs; however, your accounts payable clerk receive wages until the following week after payroll processes. This is an expense incurred for which you receive no invoice.
And, just like that, you have an accrued expense.
Remember in our second installment when we discussed “GAAP” (Scary Word No. 1) and the “matching principle?”
Expenses must be matched with the revenue that helped generate them. Therefore, you record them in the same period in which you earned the revenue.
If your payroll cycle falls in between months, you may incur the expense of your employees in the month of May, for example, but you won’t pay that expense until the month of June. So, if your payroll expense was for the month of May, then you should record it in the month of May (when it was incurred), and not in the month of June (when it was paid).
To record this transaction, you must:
- determine the cost of the expense (payroll or wages, in this case)
- debit the expense
- credit accrued expense
This provides you with a true picture of your company’s financial position for the month. The following month, when the payroll is actually paid, you would debit the accrued expense account for the expenses incurred in the previous month.
Accrued expenses commonly appear as a current liability on your balance sheet. But, in some instances, they may be a long-term liability.
Some other examples of accrued expenses are commissions, interest, taxes, employee vacations and employee bonuses.
The next time you talk commissions with your sales representatives or receive a product without an invoice, keep in mind that all of these transactions should record as accrued expenses!
"This article originally appeared on Financial Poise and is reprinted here with permission."
- EBITDA and Other Scary Words: What Did They Just Say?
- Scary Word No. 1 – GAAP
- Scary Word No. 2 – Financial Statements
- Scary Word No. 3 – Cash
- Scary Word No. 4 – Accounts Receivable
- Scary Word No. 5 – Inventory
- Scary Word No. 6 – PP&E
- Scary Word No. 7 - 'Intangible' Assets
- Scary Word No. 8 - Accounts Payable
- Scary Word No. 9 - Accrued Expenses
- Scary Word No. 10 - Commitments and Contingencies
- Scary Word No. 11 - Debt, Collateral, Covenants, Guarantees and More
- Scary Word No. 12 - "The Deferreds"
- Scary Word No. 13 - "Equity"