Your business likely has expenses it doesn't pay for upfront. From utility bills to employee salaries to property taxes, accrued expenses are everywhere.
For your next financial report to be accurate, you’ll need to know how to record and manage them effectively. Otherwise, you risk inaccurate cash flow projections, poorly planned budgets, and even poor management decision-making based on incomplete data.
In this article, we explain what they are, why you need to track them, and how to record them. Then, we finish off with three best practices for finance teams to manage these expenses effectively.
What are accrued expenses?
Accrued expenses refer to expenses your business has incurred but not yet paid for by the end of the accounting period. You make these payments in the future for goods or services you've already received.
For example, let’s say you need to pay employees bi-monthly. However, your accounting period—when your company records and tracks transactions—ends in the middle of the payroll cycle. By then, your employees have worked for one week, but you haven’t paid them yet. That week’s wages fall into an accrued expense because the work is done, but you haven't yet made the payment.
Tracking these yet-unpaid expenses is exceptionally important in financial accounting because it helps finance teams form an accurate picture of a business’s financial standing—enabling them to make more informed decisions.
These expenses are often (incorrectly) conflated with two other accounting terms—accounts payable and cash-basis accounting. Let’s compare.
Accrued Expenses vs Accounts Payable
The main difference between accrued expenses and accounts payable is that the former qualify as goods or services you account for even if you haven’t received an invoice. The latter, however, are goods or services for which you’ve received invoices but haven’t yet paid.
Accrued Expenses vs Cash Basis Accounting
The main difference between these two types of accounting is when your business records the expenses.
Accrued expenses are recorded when the good or service is incurred, regardless of when you make payment. Cash basis accounting records expenses when you make a payment: only when the money physically leaves your company bank account is the expense recognized.
What Are The Types of Accrued Expenses?
From (literally) keeping the lights on to paying your hard-working people, here are the main types of expenses that accrue:
- Salaries and wages: Refers to employee compensation for work that hasn’t been paid yet.
- Utilities: Electricity, gas, and water utilities are all expenses you pay for after you've incurred them.
- Taxes: Property and business taxes typically accrue over an accounting period, but usually aren’t due until later.
- Rent and lease payments: You accrue these expenses if your company occupies a space, but the rent is due at a later date.
- Interest on loans: Interest that accumulates but has not been paid by the end of the accounting period.
Plus, alongside these standard accrued expenses, businesses also need to consider industry-specific expenses that accrue over time, such as:
- Manufacturing: These companies often accrue additional expenses like raw materials, factory maintenance, and production labor costs.
- Service-based businesses: Consider contractor fees, client billing costs, and training and development.
- Retail: Most retail businesses accrue inventory costs, freight and shipping costs, and advertising fees.
- Non-profit organizations: Can expect to accrue grant management expenses, program services costs, and volunteer reimbursements.
How Do Accrued Expenses Impact Financial Analysis?
Here’s how these unpaid expenses impact financial analysis:
Impact on the balance sheet
Businesses record accrued expenses as liabilities or obligations to pay at a later date. By noting them down in balance sheets, finance teams can gain insight into the business's means to meet these obligations promptly. It also gives them an accurate, short-term look into the business’s working capital.
Effect on the income statement
Businesses typically record accrued expenses in the income statement when the expenses were incurred, not when they pay for these expenses. Matching expenses this way makes for a more accurate income statement reflecting a company's costs. Without noting down these expenses, companies would overstate their profits by excluding expenses they owe but have not yet paid.
Role in financial ratios and performance metrics
These unpaid expenses influence key financial ratios, or metrics used to measure a company’s financial health and performance, such as:
- Current ratio: Increasing liabilities—like accrued expenses—lowers your company’s current ratio (calculated by dividing current assets by current liabilities).
- Debt to equity ratio: These expenses also raise a company’s debt and, in turn, their debt to equity ratio. This means the company becomes more leveraged and relies on debt to finance operations.
- Profit margins: Recording accrued expenses helps finance teams get better insight into a company’s profit margins.
The Benefits And Challenges of Tracking Accrued Expenses
Reporting these expenses isn’t optional: it’s a crucial task for accounting teams. But, why? How does tracking accrued expenses benefit business? And what are the challenges of doing so? Take a look:
How To Record Accrued Expenses in 4 Steps
Here are the four steps for recording this type of expense.
1. Identify and Estimate the Expense
Begin by identifying which expenses your business has incurred, but for which you haven’t yet received an invoice. While you’ll be able to pinpoint the amount for some of these expenses, others won’t be clear right off the bat.
For example, employee salaries are easy to determine. You can check wages, contracts, and invoices. However, you might need to estimate utility or loan expenses based on other documents, such as past bills and their averages.
Let’s say you’ve identified a utility you’ve incurred, such as a water bill. After looking over bills from the last six months, you calculate an average of $600 per month. This average will serve as your accrued expense estimation until the bill arrives.
Your next step is to take that expense to the books.
2. Create and Post the Accrued Expenses Journal Entry
Once you’ve identified and estimated the expense, it’s time to record it in your accounting system through a journal entry. This method is used to keep track of every financial transaction—every entry is complete with key details such as the accounts included, whether they’re debited or credited, and the amount of money involved.
It involves two steps:
- Debiting your expense account: A record showing your business has used a product or service but has not yet paid for it. This will appear in your income statement as an expense your company had.
- Crediting your liability account: A record showing your business owes money. This unpaid obligation shows up in your balance sheet.
Once recorded, post the journal entry into your accounting system. This is essential for ensuring all your financial statements accurately reflect a given period—even though money has yet to change hands.
Let’s go back to our water bill example. After estimating the expense, you make the following entry:
- Debit utility expense: $600 (showing you’ve incurred the utility cost and haven’t paid for it yet).
- Credit utilities payable: $600 (records the amount you owe for utilities, showing you still have to pay it).
3. Reconcile the Accrued Expense
Reconciling is the process of ensuring your estimated accrued amounts match the expense amount on the actual invoice or bill. At this point, you’ve received the invoice for the expense.
This step is essential because it allows you to correct any discrepancies between your estimation and the actual amount your business owes.
Three things can happen here:
- The bill’s amount is less than your estimation.
- The bill’s amount is more than your estimation.
- The bill’s amount is the same as your estimation.
If either of the first two cases occurs, then you’ll need to revisit and adjust your expense and liability accounts.
Let’s say your utility water bill comes in at $580 instead of your estimated $600. You’ll need to lower both your expense and liability to $580.
If the amount comes to be more than your estimation—$640, for example—then you’ll need to use that number for both accounts instead.
But there’s still one thing left to do before you make the payment.
4. Reverse Entries in the Following Period
After reconciliation, you’re clear to reverse entries at the beginning of the next accounting period, right before you pay your expense. Doing so cancels out the accrued expense and ensures you don’t accidentally double-count it for the following period.
To do so, create a reversing entry and add the expense amount to your debit utilities payable account and your credit utilities expense.
In our utility water bill example, we made the following entry:
- Debit utility expense: $600
- Credit utilities payable: $600
To reverse it, you make the following entry in the next payment period:
- Debit Utilities Payable: $600
- Credit Utilities Expense: $600
This cancels out the original accrual from the records. Once you’ve paid the amount, you can record it without worrying about duplication.
Best Practices for Managing Accrued Expenses
Successfully recording and tracking this type of expense can be tricky. Even with a foundational understanding of the process, finance teams can make errors that can result in inaccurate financial analysis and skewed budget planning.
That’s why we’ve singled out three best practices to make managing them a breeze for your organization.
1. Implementing Robust Accounting Systems
Implementing an efficient system makes it easier to keep track of accrued expenses and ensure they’re all correct. To implement a robust accounting system, consider:
- Creating a chart of accounts: This is a detailed list of all the accounts you use in your business. Having one on hand makes it easier to find and review these expenses.
- Monitoring payroll and other expenses: For regular expenses such as payroll, rent, and utilities, establish a schedule for financial reporting. This ensures you won’t forget to enter them in your journal.
- Auditing accrued expenses: Conducting regular audits ensures all of these expenses are properly recorded and comply with accounting standards. With audits, you can check the entire system of accruals, and test for both accuracy and adherence to policies and laws.
2. Regular Review and Adjustment of Accruals
Your accrued expenses will often rely on estimates. There won’t always be a one-to-one match between these estimates and the actual amount of money your business owes. To ensure your records are accurate, you need to regularly review and readjust accrued expenses for each payment period.
Set up a consistent schedule for monthly or quarterly reviews, depending on your accounting period. During these sessions, pay close attention to estimates and if they reflect expenses as closely as possible. Use contracts, invoices, and any other documentation with historical data to aid in the process. Finally, be sure to monitor any invoice amount changes in the future, and readjust estimates if necessary.
3. Clear Communication Between Departments
Different departments will be responsible for different accrued expenses. For example, human resources might be in charge of employee salaries and wages, while your operations department might be in charge of utilities.
That’s why it’s crucial to have clear communication between your finance team and other departments. Consider creating a centralized system where different teams can report incurred expenses. Each department should have a designated point of contact to communicate directly with the finance team in case any issues arise. Setting clear guidelines and timelines can streamline the process and ensure your finance team is properly informed.
Facilitating Communication Between Departments with a Specialized Tool
Facilitating communication between departments isn’t difficult—provided you have the right tool for the job.
For example, Cledara lets you set budgets for your team and gives departments the independence to manage their software stack and access new tools. With Cledara, you have complete visibility over all your software spend, including views of your top spenders, team, and applications.
With complete visibility of spend, your team can stay aligned when it comes to your accrued software expenses.
By synchronizing with accounting tools, such as Xero, Sage, and Quickbooks, Cledara speeds up syncing bank statements, transactions, and invoices to make the accounting process quick and easy for your entire finance team.
Stay On Top of Accrued Expenses
Monitoring all expenses ensures you have a representation of your company’s financial health, can plan for the future, and make budget decisions based on real and accurate changes in data.
In most cases, these expenses reoccur each month, and that makes it even more important for finance teams to track them.
By staying on top of accrued expenses, you’re not just paying salaries, utilities, and taxes—you’re setting the stage for better resource allocation and maintaining a true record of your company’s obligations.
If you’re looking for a way to monitor software expenses easily and efficiently—look no further. Cledara is a software spend management platform that helps businesses monitor and report on software spending across an organization. Keep your finance team connected with complete software spend visibility.
