What are Accrued Expenses?
Accrued expenses are expenses that are recognized at the time they are incurred, even though cash has not yet been paid. These expenses are paired up against revenue via the matching principle from the GAAP (Generally Accepted Accounting Principles). For those who are unaware of the matching principle, it states that you record revenues and all related expenses in the accounting period in which they occur. This is true regardless of whether or not cash has actually been received by the seller or paid out by the buyer.
Types of Accrued Expenses
There are different types of accrued expenses. However, in this article, we focus on the more common accrued expenses that you will run into as an accountant from time to time:
- Accrued Salaries and Wages
- Accrued Interest
In demonstrating and showing examples of accrued expenses, we are using MS Excel. If you are unfamiliar with Microsoft’s spreadsheet program, be sure to check out our free Excel crash course.
Accrued Salaries and Wages
This type of accrued expense is very common and occurs regularly within company operations. Following is an example to demonstrate how and when this type of accrued expense may occur.
Corporate Finance Institute pays salaries of $58 per day in a 5-day work week every week. The last time employees were paid was on June 30, Friday. Unfortunately, due to statutory holidays occurring in the preceding week (Monday and Tuesday), employees were only paid for Wednesday, Thursday, and Friday. This means management needed to prepare adjusting entries to recognize employees have only been paid three days out of five. This is the entry that management would record:
Notice that on Friday, July 7, management would record the recognition of the accrued salaries expense. This is the salaries that have accrued over the three days, which can be found through some math: (58/5)*3.
Now, when the company reaches the end of their 5-day work week, which lands on Tuesday of next week, July 11, management records the payment of the salaries. This is shown in the second entry by debiting the salaries and wages payable account by the amount that was accrued and debiting the salaries expense account. We also credit cash to demonstrate that cash was paid for salaries. Note that salaries payable is similar to accounts payable.
Accrued interest is another type of accrued expense that is common for companies with notes payables. Notes payables are promissory notes issued by either an individual, banks, or even other companies that obligate the issuing party (the one who must pay it back) to pay back the amount stated by a certain date. Just like earlier with salaries and wages, we use an example to demonstrate what we mean.
On January 1, Corporate Finance Institute issued a 1-year promissory note to AC Bank. The terms of the promissory note were a $10,000 value along with an annual interest rate of 2%. Because the note was for a term of one year, the maturity date of the note would be December 31 of the present year. These are the journal entries that the company would record:
The very first entry on January 1 is the recording of the issuance of the note. Recall that the note’s face value was $10,000, with annual interest of 2%. The next entry on February 1 records the accrued interest for the month of January. We record interest every month to recognize the monthly interest that we are obligated to pay. All this monthly interest eventually adds up to the annual interest amount at the end of the year.
To record the monthly interest expense, we take the face value of $10,000, multiply it by the annual interest rate of 2%. This gives us $200, which is our annual interest. We then divide this annual interest by 12 (200/12) and we end up with $16.67. This will be the monthly interest that we record every month leading up to the last month, when we actually pay the interest due.
The last entry represents the payment of the note along with all interest that has accrued over the life of the note. Again, we see that there is a debit of interest payable along with a debit of interest expense. This is done because we are paying off all of the accrued interest along with the last bit of interest that accrues in December. An important thing to note is that debits must always equal credits. Otherwise, issues can arise in your financial statements, especially in the balance sheet and income statement, because these two statements are closely related to one another.
Accrued expenses are part of a larger concept known as the accrual basis of accounting. It is one of the most important concepts in accounting and without it, accountants would find it difficult to identify precisely when to record transactions. Once you think you have mastered accrued expenses, be sure to check out these related CFI articles to gain an even deeper understanding of accounting: