Understanding Accrued Expenses

Don’t take the deductibility of accrued expense lightly. It is not always as simple as it looks.

Many accountants struggle with tax deductions related to accrued expenses. At first glance, they seem simple, but when you review the details, there are several considerations that need extra attention. This is typically a concern for accrual basis taxpayers because cash basis taxpayers are, for the most part, only allowed to deduct an expense when it is paid.

Three qualifications need to be met before deductibility can be achieved:

1. All events have occurred that established the fact of the liability.   
2. The amount of the liability calculation is reasonably accurate.
3. Economic performance has occurred.

All Events Have Occurred That Established the Fact of The Liability   

An accrued expense is deductible when it is fixed in place. This means that there are no conditions or contingencies that exist that bring into question that a true liability exists. The IRS provides a bit of guidance on this matter through Ruling 2007-3. The ruling states that the mere execution of an agreement to provide service for a particular year is not enough to satisfy item one. The performance required by the agreement should be performed prior to any accrual being made.  

The Amount of The Liability Calculation Is Reasonably Accurate

An exact measure of the liability is not necessary, if a reasonably accurate amount can be determined. If the exact amount is determined to be different, the difference should be taken and accounted for in a later year in which the exact determination is made.

Economic Performance Has Occurred

While items one and two are more straight forward, item three can be more complicated. We’ll look at the nuances of several instances of accruals.

In most cases, economic performance occurs when the party to be compensated has done what it needs to earn that compensation. Economic performance may vary between different types of liabilities and taxpayers can elect to treat some, but not all, liabilities under the recurring item exception. Under this provision, taxpayers can deduct an accrued expense if the first two items above have been met and the economic performance (depending on the expense category, this is not necessarily the payment) occurs before the earlier of 8.5 months, or the filing of the return. The expense must be one that can generally be expected to be incurred year after year. Applying this exception requires an election to be made and, once the election is made, the treatment must be followed consistently going forward.

Accrued Rent/Accrued Interest

For accrual purposes, these two expenses are generally treated the same. Economic performance is achieved ratably over the period of time for the use of property (for rent) and for the amounts paid on borrowed amounts (for interest). The concept of a recurring item exception is not applicable to rent expense because that economic performance hasn’t occurred since the property has not been used for that future period yet. Treasury regulations prohibit the use of the recurring item exception with respect to accrued interest.

Accrued Services

Economic performance for services occurs as those services are provided. The recurring item exception can be applied to these accruals with a caveat; taxpayers must keep in mind the requirement of providing the service (not the payment for those services) within the earlier of 8.5 months or the filing of the return.

Accrued Compensation (Wages, Bonus, Vacation and Severance)

When it comes to accrued compensation, meaning compensation paid after year-end, the deduction of those expenses is included under the deferred compensation rules. The general rule states the deduction is not allowed until the individual has been paid. However, an exception to the rule does allow the deduction of deferred compensation that is paid within 2.5 months after year-end. Keep in mind that economic performance is still in play, meaning any accrued compensation should be for services rendered prior to the year-end. The recurring item exception does not apply to deferred compensation.

Accrued Workers Compensation, Tort Payments, Violation of Law, Breach of Contract, Rebates, Insurance, Prizes/Awards and Warranties

The first four of these accruals are simple. Economic performance can only occur upon the payment of these expenditures. The recurring item exception does not apply.

Similarly, the economic performance criteria for rebates, insurance, prizes/awards and warranties is not achieved until payment is made. However, the recurring item exception can be applied if the election has been made and the payment for any of these four expenses has been made within the earlier of 8.5 months or the filing of the return, the deduction is allowable.