As a business ages, it begins to accumulate expenses that must be recorded and tracked. Whether this transaction has occurred in the past or is set to happen in the near future, everything must be documented.
This is where the accrual basis of accounting comes in. This involves closely tracking accumulated payments, either as accrued expenses or accounts payable.
What are Accrued Expenses?
Accrued expenses (also called accrued liabilities) are liabilities that have built up over time and are now due to be paid. In bookkeeping, they are considered to be current liabilities because they are usually due within a year from the transaction.
In accounting terms, accrued expenses are charges you are obligated to pay in the future for goods and/or services already rendered. Therefore, it’s something that must be carefully tracked to ensure a company’s balance sheet is accurate.
When it comes to your cash flow, accrued expenses are adjusted and recognized on the balance sheet at the end of the accounting period. An adjusting entry is used to document goods and services that have been delivered, but not yet billed.
Examples of an Accrued Expense
An example of an accrued expense would be any utilities your business has used for the month, but the utility company has yet to send the bill. In this case, your only proof of the transaction would be the financial statements you keep. Other examples include:
- Wages that have been incurred by employee labor but payroll has yet to process (wages payable).
- Services or goods consumed prior to receiving an invoice from the vendor.
- Any accrued interest or interest expense that is owed but not yet recorded in the general ledger accounts.
What is Accrual Accounting?
As a company accrues expenses, the portion of unpaid bills continues to increase. A bookkeeper or CPA must do a little guesswork and follow the accrual method of accounting to ensure the account balance is accurate.
That means some amounts recorded in the accrued expenses payable may be estimates. However, these should always be supported by reasonable and well-documented calculations.
Think of it as a form of prepaid expenses without the payment. You are simply making note of the obligation to pay and that you have received the business rendered (goods and/or services). In fact, you could be halfway through using them but the important part is that the business has acknowledged the vendor’s receivable.
This method is the opposite of cash basis accounting which recognizes net income when money is received, not when goods or services are rendered. The cash-basis method is much less accurate than the accrual, although it seems to be more popular among small business owners.
What is Accounts Payable?
Accounts payable (referred to as “payables” or simply “AP”) represents current liabilities that are set to be paid in the near future.
These are a company’s ongoing expenses that are typically short-term debts. They must be paid in a specific time period to avoid default and maintain financial health. A default is a failure to repay a debt which we all know can have serious consequences.
Companies that buy inventory from a supplier are often allowed to pay the debt at a later date. In this case, the business is purchasing something on credit from the merchant.
Payment terms are agreed upon and when the invoice is received by AP, it must be settled within that time frame. This is usually 30 days but other terms can include 45, 60, and 90 days.
An accounts payable is essentially an extension of credit from the supplier to the manufacturer. This gives the company time to generate revenue from the inventory so that the supplier can be paid back. It allows you the space to drum up working capital and distribute funds accordingly.
Accounts payables are recognized on the balance sheet when a company buys goods or services on credit. Conversely, accrued expenses are recorded on the balance sheet at the end of an accounting period. This is done by adjusting journal entries in the ledger to formally balance the books.
While both accounts payables and accrued expenses are liabilities, they differ in kind. AP is the total amount of short-term obligations and/or debt a company has to pay. This is to its creditors (vendors) where goods and/or services were purchased on credit. With accounts payable, the supplier’s invoice must be received and is then recorded.
Subsequently, accrued expenses are the total liability that is payable for goods and/or services that have already been received (and possibly consumed). A rent expense is one example. You’ve already lived in a building for 30 days and consumed the resources before the owner asks for payment.
Where accounts payable always represents an exact amount, accrued expenses are more of a guesstimate. Since the bills and invoices have not been received, it’s up to the AP department to make an educated guess based on supporting documents like purchase orders and shipping receipts. When the invoice is finally received, the amount can be adjusted in the books to reflect 100% accuracy.
Accrued Expenses vs. Accounts Payable
If you are looking at both systems in a real-life scenario, consider a business that pays salaried employees on the first day of the following month. This is for services staff has rendered for the entire 30 days prior. So, people that worked all of June, will be paid on July 1st.
At the end of the year, on December 31st, if the income statement only recognizes salary payments that have been made, the entire month of labor from December is omitted. The accrued expenses from the employee services in December will have to go on the following year.
By contrast, if a company receives a $200 invoice for office supplies, it records a $200 credit in the accounts payable field of the ledger. It then documents a $200 debit from the expense account linked to office supplies.
Now, if anyone looks at the books in the AP category, they will see the total amount a company owes its vendors on a short-term basis. As the company makes the $200 payment, a $200 credit is added to the checking account and a $200 debit is recorded in the accounts payable column.
The glory of running a business is that you can manage it however you please. There is no form of accounting that is set in stone. Some methods work better than others depending on factors like your company size, staff availability, and technological infrastructure.
Whether you record expenses as they come or wait for an invoice, knowing the difference between accrued expenses and accounts payable is important for making effective financial decisions.