When a business records an expense at the end of reporting period for which it has not received an invoice for nor paid we call this an accrued expense. Under the accrual accounting concept the financial records recognise all flows of resources of the business not just movements in cash.
Definition of Accrued Expense
An expense is considered to be accrued when at the end of a reporting period, for either say month-end reporting or year-end reporting, the business has recorded an expense that it knows is coming up but yet to pay. It knows it has an obligation to pay but has yet received the invoice for it nor paid for it.
Accrued expenses fall into a group called “balance day adjustments”, as they are only done on a balance date for reporting purposes (internal or external).
The types of expenses may include interest on a loan, a utilities account, work carried out by a contractor that has not yet invoiced the business or the payment due on wages and salaries.
Classification of Accrued Expense
An accrued expense is brought to account as a liability, ie an obligation the business owes to a third party. In our tutorial looking specifically at liabilities, we defined these along the lines of:
” … a financial arrangement that creates an obligation on the business to expend economic benefits sometime in the future as a result of a past event”.
This is consistent with the International Financial Reporting Standards (IFRS) Conceptual Framework that sets out key definitions and terms used in accounting. If you would like some “lite” reading you can access a quick summary of the framework through this link.
If we were to break this down a bit more, you can tell I once worked in accounting policy, using a utility account as an example.
The business and the utility company have a contract in place. They agree to provide the business with power and in exchange the business agrees to pay for this power.
Creates an Obligation on the Business
As utilities are normally paid for in arrears, the consumption of power creates a financial obligation to now pay for it – as per the contract in place.
To Expend Future Economic Benefits
The consumption of power must create a financial obligation on the business to expend “economic benefits”. Although not always, this is a fancy way of saying the business has to spend money.
As a Result of Past Events
As at the end of the reporting period the past events is the daily consumption of power. It can’t be for the future consumption; as obviously this is a future event.
Accrued Expense Example and Journal Entries
So lets now take the utilities account example and work through the accounting entries required to bring this to account.
ABC Ltd receives it’s utility account on the 15th day of the month. This is for power consumed from the 11th of the previous month through to the 10th of the month the bill is received in. The utility bill received on April 15 is $2,400. ABC’s end-of-year accounts are prepared as at 31 March. ABC’s accounts team need to prepare an accrual in the accounts for the amount of power consumed up until 31 March.
The facts we have are:
- the billing for this period is 30 days (11 March to 10 April); and
- the power consumption days for this bill that relate to year-end 31 March is 20 days (11 March to 31 March).
The simple calculation we now need is the apportion the $2,400:
(20 days / 30 days) x $2,400 = $1,600
The journal entry required at year-end is:
|31 March||Power Expense||$1,600|||
This entry increases ABC’s expenses by $1,600 with a debit to the power expense account. And increases its liabilities by the same amount with a credit to the accrued power account.
We now need to deal with when the utility bill is actually paid. ABC pays these by month-end in the month of the bill. The entry below may be done when the account is paid or on April 1. The reason for the reversal of the accrual we did for year-end reporting on the next day is to keep the accounting system cleaner by removing these “one-off” balance day adjustment entries for reporting.
|1 April||Accrued Power||$1,600|||
When the utility bill is paid ABC’s cash payments system would make the following entry
|30 April||Power Expense||$2,400|||
At April month-end the monthly report would show a power consumption of $800 (ie $2,400 debit – $1,600 credit = $800 debit to the power expense account). Of course we have not mentioned the end-of month accrual for utilities which ABC may do for its internal management reporting.
That brings us to the end of the accrued expense tutorial. We looked at how these expenses are recognised as a liability and expense in the accounts even though they haven’t been paid. And we looked at the journal entries required to reflect them in the financial statements. Remember the reversal of balance day adjustments keeps the accounting system cleaner and ensures they are not forgotten about in future accounting periods.