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 Accrued Interest?

In accounting, accrued interest refers to the amount of interest that has been incurred, as of a specific date, on a loan or other financial obligation but has not yet been paid out. Accrued interest can either be in the form of accrued interest revenue, for the lender, or accrued interest expense, for the borrower.

The term accrued interest also refers to the amount of bond interest that has accumulated since the last time a bond interest payment was made.

Understanding Accrued Interest

Accrued interest is calculated as of the last day of the accounting period. For example, assume interest is payable on the 20th of each month, and the accounting period is the end of each calendar month. The month of April will require an accrual of 10 days of interest, from the 21st to the 30th. It is posted as part of the adjusting journal entries at month-end.

Accrued interest is reported on the income statement as a revenue or expense, depending on whether the company is lending or borrowing. In addition, the portion of revenue or expense yet to be paid or collected is reported on the balance sheet as an asset or liability. Because accrued interest is expected to be received or paid within one year, it is often classified as a current asset or current liability.

Accrual Accounting and Accrued Interest

Accrued interest is a result of accrual accounting, which requires that accounting transactions be recognized and recorded when they occur, regardless of whether payment has been received or expended at that time. The ultimate goal when accruing interest is to ensure that the transaction is accurately recorded in the right period. Accrual accounting differs from cash accounting, which recognizes an event when cash or other forms of consideration trade hands.

The revenue recognition principle and matching principle are both important aspects of accrual accounting, and both are relevant in the concept of accrued interest. The revenue recognition principle states that revenue should be recognized in the period in which it was earned, rather than when payment is received. The matching principle states that expenses should be recorded in the same accounting period as the related revenues.

To illustrate how these principles impact accrued interest, consider a business that takes out a loan to purchase a company vehicle. The company owes the bank interest on the vehicle on the first day of the following month. The company has use of the vehicle for the entire prior month, and is, therefore, able to use the vehicle to conduct business and generate revenue.

At the end of each month, the business will need to record interest that it expects to pay out on the following day. In addition, the bank will be recording accrued interest income for the same one-month period because it anticipates the borrower will be paying it the following day.

Accrued Interest Example – Accounting

Consider the following example. Let us assume there is a $20,000 loan receivable with an interest rate of 7.5%, on which payment has been received for the period through the 20th day of the month. In this scenario, to record the extra amount of interest revenue that was earned from the 21st to the 30th of the month, the calculation would be as follows:

• (7.5% x (10 / 365)) x $20,000 = $41.10

The amount of accrued interest for the party who is receiving payment is a credit to the interest revenue account and a debit to the interest receivable account. The receivable is consequently rolled onto the balance sheet and classified as a short-term asset. The same amount is also classified as revenue on the income statement.

The accrued interest for the party who owes the payment is a credit to the accrued liabilities account and a debit to the interest expense account. The liability is rolled onto the balance sheet as a short-term liability, while the interest expense is presented on the income statement.

Both cases are posted as reversing entries, meaning that they are subsequently reversed on the first day of the following month. This ensures that when the cash transaction occurs in the following month, the net effect is only the portion of the revenue or expense that was earned or incurred in the current period stays in the current period.

Using the example above, $123.29 (7.5% x (30/365) x $20,000) is received by the lending company on the 20th day of the second month. Of that, $41.10 related to the prior month and was booked as an adjusting journal entry at the prior month end to recognize the revenue in the month it was earned. Because the adjusting journal entry reverses in the second month, the net effect is that $82.19 ($123.29 – $41.10) of the payment is recognized in the second month. That is equivalent to the 20 days worth of interest in the second month.

Accrued Interest Example – Bonds

Accrued interest is an important consideration when purchasing or selling a bond. Bonds offer the owner compensation for the money they have lent, in the form of regular interest payments. These interest payments, also referred to as coupons, are generally paid semiannually.

If a bond is bought or sold at a time other than those two dates each year, the purchaser will have to tack onto the sales amount any interest accrued since the previous interest payment. The new owner will receive a full 1/2 year interest payment at the next payment date. Therefore, the previous owner must be paid the interest that accrued prior to the sale.

Let’s assume you are interested in buying a bond with a face value of $1,000 and a 5% semiannual coupon. The interest payment is made twice a year on June 1 and December 1 and you plan to buy the bond on September 30. How much accrued interest would you have to pay?

Bond markets use a number of slightly differing day-count conventions to calculate the exact amount of accrued interest. Since most U.S. corporate and municipal bonds use the 30/360 convention, which assumes that each month has 30 days (regardless of the actual number of days in a particular month), we will use that day-count convention in this example.

Step 1: Calculate the exact number of days between the date of the last coupon payment (June 1) and your purchase date (September 30). In this example, the number of days (based on the 30/360 convention) is 120 days.

Step 2: Calculate accrued interest by multiplying the day count by the daily interest rate and face value of the bond.

Thus, accrued interest = 120 x (5% / 360) * $1,000 = $16.67

Step 3: Add the accrued interest to the face value of the bond to get your purchase price.

Purchase price of bond = $1,000 + $16.67 = $1,016.67

On the next coupon payment date (December 1), you will receive $25 in interest. But since you paid $16.67 in accrued interest when you purchased the bond, the net interest received by you is $8.33 ($25 – $16.67), which is precisely the amount of interest you should have received for the 60 days that you owned the bond until the next coupon payment (September 30 to December 1).