An accrued expense is an expense that has been incurred, but for which there is not yet any expenditure documentation. In place of the expenditure documentation, a journal entry is created to record an accrued expense, as well as an offsetting liability (which is usually classified as a current liability in the balance sheet). In the absence of a journal entry, the expense would not appear at all in the entity's financial statements in the period incurred, which would result in reported profits being too high in that period. In short, accrued expenses are recorded to increase the accuracy of the financial statements, so that expenses are more closely aligned with those revenues with which they are associated.
A prepaid expense is the reverse of an accrued expense, since a liability is being paid before the underlying service or asset has been consumed. Consequently, a prepaid asset initially appears on the balance sheet as an asset.
Accrued Expenses in Practice
Examples of expenses that are are commonly accrued include:
Goods received and consumed or sold, for which no supplier invoice has yet been received
Services received, for which no supplier invoice has yet been received
Taxes incurred, for which no invoice from a government entity has yet been received
An example of an accrued expense is a situation where a company receives office supplies from a supplier near the end of a month, but has not yet received an invoice from the supplier by the time the company closes its books for the month. To properly record this expense in the month of receipt, the accounting staff records an expense in the supplies expense account with a debit in the amount that it expects to be billed by the supplier, and records a credit to an accrued expenses liability account. Thus, if the amount of the office supplies were $500, the journal entry would be a debit of $500 to the office supplies expense account and a credit of $500 to the accrued expenses liability account.
The journal entry is normally created as an automatically reversing entry, so that the accounting software automatically creates an offsetting entry as of the beginning of the following month. Then, when the supplier eventually submits an invoice to the entity, it cancels out the reversed entry.
To continue with the preceding example, the $500 entry would reverse in the following month, with a credit to the office supplies expense account and a debit to the accrued expenses liability account. The company then receives the supplier invoice for $500, and records it normally through the accounts payable module of the accounting software, resulting in a debit to the office supplies expense account and a credit to the accounts payable account. The net result in the following month is therefore no new expense recognition at all, with the liability for payment shifting to the accounts payable account.
Realistically, the amount of an expense accrual is only an estimate, and so is likely to be somewhat different from the amount of the supplier invoice that arrives at a later date. Consequently, there is usually a small additional amount of expense or negative expense recognition in the following month, once the journal entry reversal and the amount of the supplier invoice are netted against each other.
From a practical perspective, immaterial expenses are not accrued, since it requires too much work to create and document the related journal entries. Further, a large number of accrued expense journal entries will slow down the month-end closing process.
Examples of Accrued Expense Journal Entries
Office supplies received and there is no supplier invoice as of month-end: Debit to office supplies expense, credit to accrued expenses.
Employee hours worked but not paid as of month-end: Debit to wages expense, credit to accrued expenses.
Benefit liability incurred and there is no supplier invoice as of month-end: Debit to employee benefits expense, credit to accrued expenses.
Income taxes are accrued based on income earned. Debit to income tax expense, credit to accrued expenses.
The first three entries should reverse in the following month. Income taxes are typically retained as accrued expenses until paid.