Financial analysis is an important part of investing. It lets you determine whether the company you plan to invest in has a strong financial foundation or not. One of the many aspects that you need to examine when financially analysing a company is accrued expenses. But what exactly is the meaning of accrued expenses and how is it treated in accounting? Here is everything you need to know about this unique financial concept.
What does the term ‘accrued’ mean in accounting?
In accounting, the term "accrued" refers to the recognition of revenue or expenses before the cash transaction occurs. Companies widely use accrual accounting, where transactions are recorded when they are incurred, regardless of when the cash is exchanged.
What are accrued expenses?
Now that you know the meaning of accrued in accounts, let us look at what accrued expenses are.
Accrued expenses are the expenses that a company has incurred but has not yet paid by the end of an accounting period. Such expenses are recorded as current liabilities and are displayed on the balance sheet of the company even though the actual payment of the expenses has not been made.
Examples of accrued expenses
Here are a few hypothetical examples to help you better understand the meaning of accrued expenses.
Utility payments
The expenses for utilities like electricity, water and gas are classic examples of accrued expenses. Since these services are utilised throughout the accounting period, the expenses are recorded during the period in which they are consumed, irrespective of when the bills are received or the payment is made.
Let us assume that the electricity bill for a company is generated on a bi-monthly basis. The due date for payment is 30 days from the date of bill generation. Now, since the company follows the accrual accounting method, the expenses are recorded as soon as they accrue (once the bi-monthly period ends) and not when the company actually makes the payment.
Wages and salaries
The wages and salaries earned by employees but not yet paid at the end of the accounting period are also examples of accrued expenses. In the context of accounting, the meaning of accrued wages includes salaries, bonuses and commissions owed to employees for the work performed.
Interest and rent payments
Even if the interest payments on a loan or credit facility are not due until a later date, the interest expense is recorded on the books. The same goes for rent payments as well. The rent for a premises is recognised in the appropriate accounting period, even if the payment to the landlord is made at a later date.
Accounting treatment of accrued expenses
As an investor, it is not enough to simply understand the meaning of accrued expenses. You also need to know how they are accounted for. This can help you analyse the financials of a company better.
As you have already seen, companies that follow accrual accounting standards record accrued expenses on their books as soon as they incur them. However, since these expenses represent future cash payments that the company needs to make, they are recognised as current liabilities under the balance sheet.
At the end of each accounting period, the recorded accrued expenses are adjusted for partial or full payments to reflect the actual amount owed. This adjustment ensures that the financial statements accurately portray the company's financial position and performance.
How are accrued expenses different from accounts payable?
Accrued expenses and accounts payable are terms that companies often use in their financial statements. Contrary to popular opinion the meaning of accrued expenses and accounts payable are not the same. In fact, they are quite different. Knowing the difference between the terms is crucial for financial analysis.
To put it simply, accrued expenses are expenses that the company has incurred but has not yet received an invoice or paid for them.
Accounts payable, on the other hand, are the goods and services for which the company has received an invoice but is yet to pay for them. And just like accrued expenses, accounts payable are also recorded as current liabilities on the company’s balance sheet.
There is also another term that is widely used in financial statements - prepaid expenses. Unlike the other two terms, prepaid expenses represent goods and services for which the company has paid in advance even before receiving them. These expenses are recognised as a current asset and are listed on the balance sheet as such.
Advantages of accrued expenses
Recognising accrued expenses can be highly beneficial for companies. Here is a list of some of the major advantages they get to enjoy.
Transparency
Accrued expenses provide stakeholders with transparent and reliable information on the various expenses the company has incurred during a specific period.
Accurate financial reporting
By recognising expenses as and when they incur, companies can enhance the accuracy of their financial statements.
Cash flow management
Accrued expenses also allow businesses to manage their cash flow more effectively by providing a more realistic view of their financial obligations.
Disadvantages of accrued expenses
Although accrued expenses have a lot of advantages, they do have a few downsides. Here is a quick overview of a couple of them.
Complexity
Recognising and recording accrued expenses can get very complex, especially for companies with numerous accruals across different expense categories. Ensuring accurate accruals and adjustments requires more manpower and can be time-consuming.
Potential for errors
Accrued expenses are subject to estimation errors, especially when the invoice has not been received. This could lead to a significant difference between the accrued expenses and the actual expenses incurred, which can distort the financial statements.
Conclusion
With this, you must now be aware of what accrued expenses are. They are a fundamental aspect of accounting that allows businesses to recognise expenses as and when they incur them instead of when they are actually paid out. Despite the complexities and disadvantages involved, accounting for accrued expenses allows companies to ensure accurate financial reporting and helps them manage their financial obligations better.
