What Is an Accrued Expense?

An accrued expense, also known as accrued liabilities, is an accounting term that refers to an expense that is recognized on the books before it has been paid. The expense is recorded in the accounting period in which it is incurred.

Understanding Accrued Expenses

Since accrued expenses represent a company’s obligation to make future cash payments, they are shown on a company’s balance sheet as current liabilities. An accrued expense can be an estimate and differ from the supplier’s invoice that will arrive at a later date. Following the accrual method of accounting, expenses are recognized when they are incurred, not necessarily when they are paid.

An example of an accrued expense is when a company purchases supplies from a vendor but has not yet received an invoice for the purchase. Other forms of accrued expenses include interest payments on loans, warranties on products or services received, and taxes—all of which have been incurred or obtained, but for which no invoices have been received nor payments made. Employee commissions, wages, and bonuses are accrued in the period they occur although the actual payment is made in the following period.

Accrual vs. Cash Basis Accounting

Accrual accounting differs from cash basis accounting, which records financial events and transactions only when cash is exchanged—often resulting in the overstatement and understatement of income and account balances.

Although the accrual method of accounting is labor-intensive because it requires extensive journaling, it is a more accurate measure of a company’s transactions and events for each period. This more complete picture helps users of financial statements to better understand a company’s present financial health and predict its future financial position.

Accrued Expenses vs. Prepaid Expenses

Accrued expenses are the opposite of prepaid expenses. Prepaid expenses are payments made in advance for goods and services that are expected to be provided or used in the future. While accrued expenses represent liabilities, prepaid expenses are recognized as assets on the balance sheet. This is because the company is expected to receive future economic benefit from the prepayment.

On the other hand, an accrued expense is an event that has already occurred in which cash has not been a factor. Not only has the company already received the benefit, it still needs to remit payment. Therefore, it is literally the opposite of a prepayment; an accrual is the recognition of something that has already happened in which cash is yet to be settled.

Advantages and Disadvantages of Accrued Expenses

Advantages

Accrued expenses theoretically make a company’s financial statements more accurate. While the cash method is more simple, accrued expenses strive to include activity that may not have fully been incurred but will still happen. Consider an example where a company enters into a contract to incur consulting services. If the company receives an invoice for $5,000, accounting theory states the company should technically recognize this transaction because it is contractually obligated to pay for the service.

Accrued expenses also may make it easier for companies to plan and strategize. Accrued expenses often yield more consistent financial results as companies can include recurring transactions in their financial reports that may not yet have been paid. In addition, accrued expenses may be a financial reporting requirement depending on the company and their Securities and Exchange Commission filing requirements.

Disadvantages

Because of additional work of accruing expenses, this method of accounting is more time-consuming and demanding for staff to prepare. There is a greater chance of misstatements, especially is auto-reversing journal entries are not used. In addition, a company runs of the risk of accidently accruing an expense that they may have already paid.

Last, the accrual method of accounting blurs cash flow and cash usage as it includes non-cash transactions that have not yet impacted bank accounts. For a large company, the general ledger will be flooded with transactions that report items that have had no bearing on the company’s bank statement nor impact to the current amount of cash on hand.

Special Considerations

Reversing Entries

A critical component to accrued expenses is reversing entries, journal entries that back out a transaction in a subsequent period.

Accrued expenses are not meant to be permanent; they are meant to be temporary records that take the place of a true transaction in the short-term. Every accrued expense must have a reversing entry; without the reversing entry, a company risks duplicating transactions by recording both the actual invoice when it gets paid as well as the accrued expense.

Month-End/Year-End

Accrued expenses are prevalent during the end of an accounting period. A company often attempts to book as many actual invoices it can during an accounting period before closing its accounts payable ledger. Then, supporting accounting staff analyze what transactions/invoices might not have been recorded by the AP team and book accrued expenses.

For companies that are responsible for external reporting, accrued expenses play a big part in wrapping up month-end, quarter-end, or fiscal year-end processes. A company usually does not book accrued expenses during the month; instead, accrued expenses are booked during the close period.

Example of Accrued Expense

A company pays its employees’ salaries on the first day of the following month for services received in the prior month. So, employees that worked all of November will be paid in December. If on Dec. 31, the company’s income statement recognizes only the salary payments that have been made, the accrued expenses from the employees’ services for December will be omitted.

Because the company actually incurred 12 months’ worth of salary expenses, an adjusting journal entry is recorded at the end of the accounting period for the last month’s expense. The adjusting entry will be dated Dec. 31 and will have a debit to the salary expenses account on the income statement and a credit to the salaries payable account on the balance sheet.

When the company’s accounting department receives the bill for the total amount of salaries due, the accounts payable account is credited. Accounts payable is found in the current liabilities section of the balance sheet and represents the short-term liabilities of a company. After the debt has been paid off, the accounts payable account is debited and the cash account is credited.

The Bottom Line

Companies using the accrual method of accounting recognize accrued expenses, costs that have not yet been paid for but have already been incurred. Accrued expenses make a set of financial statements more consistent by recording charges in specific periods, though it takes more resources to perform this type of accounting. While the cash method of accounting recognizes items when they are paid, the accrual method recognizes accrued expenses based on when service is performed or received. 

What Is Accrual Accounting?

Accrual accounting is a financial accounting method that allows a company to record revenue before receiving payment for goods or services sold and record expenses as they are incurred.

In other words, the revenue earned and expenses incurred are entered into the company’s journal regardless of when money exchanges hands. Accrual accounting is usually compared to cash basis of accounting, which records revenue when the goods and services are actually paid for.

Learn more about accrual accounting and how it differs from the other popular accounting method, cash accounting.

How Accrual Accounting Works

The general concept of accrual accounting is that accounting journal entries are made when a good or service is provided rather than when payment is made or received. Entries are also made for debts and payments due.

This method allows the current and future cash inflows or outflows to be combined to give a more accurate picture of a company’s current and long-term finances.

Accrual accounting follows the matching principal, which states that revenues and expenses should be recorded in the same period.

Accrual accounting is encouraged by International Financial Reporting Standards(IFRS) and Generally Accepted Accounting Principles (GAAP). As a result, it has become the standard accounting practice for most companies except for very small businesses and individuals.

Qualifying for Accrual Accounting

Larger companies are required to use the accrual method of accounting if their average gross receipt of revenues is more than $25 million over the previous three years. If a company does not meet the average revenue requirement, it can choose to use cash basis or accrual as its accounting method.

Accrual accounting is always required for companies that carry inventory or make sales on credit, regardless of the company size or revenue.

Benefits of Accrual Accounting

The accrual method does provide a more accurate picture of the company’s current condition, but its relative complexity makes it more expensive to implement.

This method arose from the increasing complexity of business transactions and a desire for more accurate financial information. Selling on credit, and projects that provide revenue streams over a long period, affect a company’s financial condition at the time of a transaction. Therefore, it makes sense that such events should also be reflected in the financial statements during the same reporting period that these transactions occur.

Under accrual accounting, firms have immediate feedback on their expected cash inflows and outflows, making it easier for businesses to manage their current resources and plan for the future.

Accrual Accounting vs. Cash Accounting

Accrual accounting can be contrasted with cash accounting, which recognizes transactions only when there is an exchange of cash. Additionally, cash basis and accrual differ in the way and time transactions are entered.

Cash Basis of Accounting

Cash accounting uses transactions when payments are made. For example, consider a consulting company that provides a $5,000 service to a client on Oct. 30. The client received the bill for services rendered and made a cash payment on Nov. 25. Under the cash basis method, the consultant would record an owed amount of $5,000 by the client on Oct. 30, and enter $5,000 in revenue when it is paid on Nov. 25 and record it as paid.

Accrual Basis of Accounting

In contrast, accrual accounting uses a technique called double-entry accounting. When the consulting company provided the service, it would enter a debit of $5,000 in accounts receivable (debits increase an asset account). When the payment is made on Nov. 25, the consultant credits (credits decrease an asset account) the accounts receivable by $5,000 and credits the service revenues account, a revenue account (credits increase a revenue account ) with $5,000.

The received capital can then be moved to other accounts, such as free cash, if needed—the company uses the same double-entry method to enter which account the capital came from and is moved to.

The Bottom Line

Accrual accounting is an accounting method in which payments and expenses are credited and debited when earned or incurred. Accrual accounting differs from cash basis accounting, where expenses are recorded when payment is made and revenues recorded when cash is received.

Accrual accounting uses double-entry accounting, where there are generally two accounts used when entering a transaction. This method is more accurate than cash basis accounting because it tracks the movement of capital through a company and helps it prepare its financial statements.

What Is Accretion?

Accretion is the gradual and incremental growth of assets and earnings due to business expansion, a company’s internal growth, or a merger or acquisition. 

In finance, accretion is also the accumulation of the additional income an investor expects to receive after purchasing a bond at a discount and holding it until maturity. The most well-known applications of financial accretion include zero-coupon bonds or cumulative preferred stock.

Understanding Accretion

In corporate finance, accretion is the creation of value through organic growth or through a transaction. For example, when new assets are acquired at a discount or for a cost that is below their perceived current market value (CMV). Acccretion can also occur by acquiring assets that are anticipated to grow in value after the transaction.

In securities markets, purchasing bonds below their face or par value is considered buying at a discount, whereas purchasing above the face value is known as buying at a premium. In finance, accretion adjusts the cost basis from the purchase amount (discount) to the anticipated redemption amount at maturity. For example, if a bond is purchased for an amount totaling 80% of the face amount, the accretion is 20%.

Factoring in Bond Accounting

As interest rates increase, the value of existing bonds declines, which means that bonds trading in the market decline in price to reflect the interest rate increase. Since all bonds mature at the face amount, the investor recognizes additional income on a bond purchased at a discount, and that income is recognized using accretion.

Bond Accretion (Finance)

The rate of accretion is determined by dividing the discount by the number of years in the term. In the case of zero coupon bonds, the interest acquired is not compounding. While the bond’s value increases based on the agreed-upon interest rate, it must be held for the agreed-upon term before it can be cashed out.

Assume that an investor purchased a $1,000 bond for $860 and the bond matures in 10 years. Between the bond’s purchase and maturity dates, the investor needs to recognize additional income of $140. When the bond is purchased, the $140 is posted to a discount on the bond account. Over the next 10 years, a portion of the $140 is reclassified into the bond income account each year, and the entire $140 is posted to income by the maturity date.

Earnings Accretion (Accounting)

The earnings-per-share (EPS) ratio is defined as earnings available to common shareholders divided by average common shares outstanding, and accretion refers to an increase in a firm’s EPS due to an acquisition.

Examples of Accretion

For example, assume that a firm generates $2,000,000 in available earnings for common shareholders and that 1,000,000 shares are outstanding; the EPS ratio is $2. The company issues 200,000 shares to purchase a company that generates $600,000 in earnings for common shareholders. The new EPS for the combined companies is computed by dividing its $2,600,000 earnings by 1,200,000 outstanding shares, or $2.17. Investment professionals refer to the additional earnings as accretion due to the purchase.

As another example, if a person purchases a bond with a value of $1,000 for the discounted price of $750 with the understanding it will be held for 10 years, the deal is considered accretive. The bond pays out the initial investment plus interest. Depending on the type of bond purchase, interest may be paid out at regular intervals, such as annually, or in a lump sum upon maturity. If the bond purchase is a zero-coupon bond, there is no interest accrual.

Instead, it is purchased at a discount, such as the initial $750 investment for a bond with a face value of $1,000. The bond pays the original face value, also known as the accreted value, of $1,000 in a lump sum upon maturity.

A primary example within corporate finance is the acquisition of one company by another. First, assume the earnings per share of Corporation X is listed as $100, and earnings per share of Corporation Y is listed as $50. When Corporation X acquires Corporation Y, Corporations X’s earnings per share increase to $150. This deal is 50% accretive due to the increase in value.

However, sometimes, long-term debt instruments, like car loans, become short-term instruments when the obligation is expected to be fully repaid within one year. If a person takes out a five-year car loan, the debt becomes a short-term instrument after the fourth year.

What Is an Accredited Investor?

An accredited investor is an individual or a business entity that is allowed to trade securities that may not be registered with financial authorities. They are entitled to this privileged access by satisfying at least one requirement regarding their income, net worth, asset size, governance status, or professional experience.

In the U.S., the term accredited investor is used by the Securities and Exchange Commission (SEC) under Regulation D to refer to investors who are financially sophisticated and have a reduced need for the protection provided by regulatory disclosure filings. Accredited investors include high-net-worth individuals (HNWIs), banks, insurance companies, brokers, and trusts.

Understanding Accredited Investors

Accredited investors are legally authorized to purchase securities that are not registered with regulatory authorities like the SEC. Many companies decide to offer securities to this class of accredited investors directly. Because this decision allows companies exemption from registering securities with the SEC, it can save them a lot of money.

This type of share offering is referred to as a private placement. It has the potential to present these accredited investors with a great deal of risk. Therefore authorities need to ensure that they are financially stable, experienced, and knowledgeable about their risky ventures.

When companies decide to offer their shares to accredited investors, the role of regulatory authorities is limited to verifying or offering the necessary guidelines for setting benchmarks to determine who qualifies as an accredited investor. Regulatory authorities help determine if the applicant possesses the necessary financial means and knowledge to take the risks involved in investing in unregistered securities.

Accredited investors also have privileged access to venture capital, hedge funds, angel investments, and deals involving complex and higher-risk investments and instruments.

Requirements for Accredited Investors

The regulations for accredited investors vary from one jurisdiction to the other and are often defined by a local market regulator or a competent authority. In the U.S, the definition of an accredited investor is put forth by SEC in Rule 501 of Regulation D.

To be an accredited investor, a person must have an annual income exceeding $200,000 ($300,000 for joint income) for the last two years with the expectation of earning the same or a higher income in the current year. An individual must have earned income above the thresholds either alone or with a spouse over the last two years. The income test cannot be satisfied by showing one year of an individual’s income and the next two years of joint income with a spouse.

A person is also considered an accredited investor if they have a net worth exceeding $1 million, either individually or jointly with their spouse. This amount cannot include a primary residence. The SEC also considers a person to be an accredited investor if they are a general partner, executive officer, or director for the company that is issuing the unregistered securities.

An entity is considered an accredited investor if it is a private business development company or an organization with assets exceeding $5 million. Also, if an entity consists of equity owners who are accredited investors, the entity itself is an accredited investor. However, an organization cannot be formed with the sole purpose of purchasing specific securities.

Recent Changes to the Accredited Investor Definition

Recently, the U.S. Congress modified the definition of an accredited investor to include registered brokers and investment advisors.

On Aug. 26, 2020, the U.S. Securities and Exchange Commission amended the definition of an accredited investor. According to the SEC’s press release, “the amendments allow investors to qualify as accredited investors based on defined measures of professional knowledge, experience or certifications in addition to the existing tests for income or net worth. The amendments also expand the list of entities that may qualify as accredited investors, including by allowing any entity that meets an investments test to qualify.”

Among other categories, the SEC now defines accredited investors to include the following: individuals who have certain professional certifications, designations, or credentials; individuals who are “knowledgeable employees” of a private fund; and SEC- and state-registered investment advisors.

Purpose of Accredited Investor Requirements 

Any regulatory authority of a market is tasked with both promoting investment and safeguarding investors. On one hand, regulators have a vested interest in promoting investments in risky ventures and entrepreneurial activities because they have the potential to emerge as multi-baggers in the future. Such initiatives are risky, may be focused on concept-only research and development activities without any marketable product, and may have a high chance of failure. If these ventures are successful, they offer a big return to their investors. However, they also have a high probability of failure.

On the other hand, regulators need to protect less-knowledgeable, individual investors who may not have the financial cushion to absorb high losses or understand the risks associated with their investments. Therefore, the provision of accredited investors allows access for both investors who are financially well-equipped, as well as investors who are knowledgeable and experienced.

There is no formal process for becoming an accredited investor. Rather, it is the responsibility of the sellers of such securities to take a number of different steps in order to verify the status of entities or individuals who wish to be treated as accredited investors. 

Individuals or parties who want to be accredited investors can approach the issuer of the unregistered securities. The issuer may ask the applicant to respond to a questionnaire to determine if the applicant qualifies as an accredited investor. The questionnaire may require various attachments: account information, financial statements, and a balance sheet to verify the qualification. The list of attachments can extend to tax returns, W-2 forms, salary slips, and even letters from reviews by CPAs, tax attorneys, investment brokers, or advisors. Additionally, the issuers may also evaluate an individual’s credit report for additional assessment.

Example of an Accredited Investor

For example, suppose there is an individual whose income was $150,000 for the last three years. They reported a primary residence value of $1 million (with a mortgage of $200,000), a car worth $100,000 (with an outstanding loan of $50,000), a 401(k) account with $500,000, and a savings account with $450,000. While this individual fails the income test, they are an accredited investor according to the test on net worth, which cannot include the value of an individual’s primary residence. Net worth is calculated as assets minus liabilities.

This person’s net worth is exactly $1 million. This involves a calculation of their assets (other than their primary residence) of $1,050,000 ($100,000 + $500,000 + $450,000) less a car loan equaling $50,000. Since they meet the net worth requirement, they qualify to be an accredited investor.

The Bottom Line

The accredited investor rules are designed to protect potential investors with limited financial knowledge from risky ventures and losses they may be ill equipped to withstand. But on the flip side, it gives people already starting off with large financial assets a major advantage over those with more modest assets.