A Simple Guide on Accrued Expenses and Accrual Accounting
While doing accounting for your client’s you must have encountered the term accrued expenses. For those who are unaware, these expenses are liabilities for goods and services your clients have incurred but have not paid for by the end of the accounting year. These expenses are important for maintaining accuracy in the financial reporting, thus enabling accounting practices like you to produce more accurate financial statements for your clients and for regulatory bodies like HMRC and Companies House.
Some common accrual expenses are labour costs, utility costs, and purchases made but not yet invoiced by the supplier. In this guide, we will systematically understand accrued expenses, why they are used, how they are calculated, and how they are different from prepaid expenses and accounts payable.
Why Use Accrued Expenses?
Accrual accounting aids in keeping an up-to-date record of your client’s company’s financial transactions. It will guarantee far more accuracy in the financial health records, giving the stakeholders a clearer view. Conversely, there may be a lag between incurred costs and payments in cash-based accounting. As a result, obligations will look smaller than they actually are and revenue will appear more than it actually is. This makes forecasting for business operations challenging and can impede cash flow and future tax obligations.
The Drawbacks of Using Accrued Expenses
One of the major drawbacks of accrual accounting is its complexity, which means that there will be more work, which will increase the possibility of mistakes. That’s why accrued accounting is ideal for your large business clients, while cash-basis accounting is much more suited for your medium-sized business clients.
Even if you have a capable accounting team to handle the accrual accounting, you will have to consider the complexities involved. Also, if your accounting practice handles multiple clients, your workload and the chances of errors will increase. To avoid this, you should outsource the accrued expenses accounting task to an accounting service provider offering bookkeeping outsourcing services.
Difference Between Accrued Expenses and Prepaid Expenses and Accounts Payable
Let’s first understand the difference between accrued and prepaid expenses, which are the opposite.
Accrued expenses: These have been incurred but have yet to be paid. They are recorded as liabilities on the balance sheet and expenses on the income statement in the period they are incurred.
Prepaid expenses: These are payments made in advance for goods or services to be received in the future. They are recorded as assets and gradually expensed over time as the benefits are realised.
On the other hand, both accrued expenses and accounts payable are recorded down in balance sheet as current liabilities. The only difference between them is that accrued expenses are accumulated liabilities. In other words, they are costs that have built up over time. By contrast, accounts payable are specific, fixed costs that need to be paid in the near future.
What is the Accrual Accounting Method?
Accrual accounting explains the process of recording costs in financial statements when they are incurred instead of when they are paid. On the brighter side, your clients can get accrued revenues, which are nothing but payments that they are expecting but have not been made yet.
It is important to mention that accrual accounting is different from cash accounting, under which entry is made in the financial statement only when cash changes hands. Also, there is risk associated with cash accounting. That risk is misrepresenting your client’s financial position because it does not cover all the liabilities that are required to be paid in the future. That’s one major reason why cash accounting is not recommended for large businesses in the UK.
How to Calculate Accrued Expenses
It is important to note that all expenses, including accrued expenses, are divided into operating and non-operating expenses. Operating expenses are the expenses incurred by your clients to run their day-to-day business operations. These expenses happen on a regular basis and are predictable, such as paying employee salaries and purchasing goods and services.
Non-operating expenses are expenses incurred by your clients that are not directly related to running business operations. Examples of non-operating expenses are the cost of relocating a business to a new location or interest on a loan taken.
Separating operating expenses from non-operating ones is required to get a clear picture of the client’s business’s ongoing financial performance. By removing non-regular expenses or any expenses that have occurred rarely, accounting practices like yours will be able to see and show stakeholders the financial performance of their clients on an ongoing basis.
How Will You Reconcile Accrued Expenses?
When you use accrual accounting, you must reconcile accrued and paid expenses to keep your client’s books balanced over time. While doing this, you may require professional help, which can be provided if you choose to outsource this task to a professional service provider that offers bookkeeping outsourcing services like Corient, but here’s the basic process as an overview:
When your client accrues the expense:
- Enter a debit entry against the expense account;
- Enter a credit against the accrued liability.
By debiting the expense account, you’re increasing the amount shown on your income statement as owed, and crediting the liability correspondingly increases your client’s business liabilities on the balance sheet.
Once the payment has been made, you need to reconcile the accounts.
To balance everything up:
- Debit the accrued liability;
- Credit an asset account – often cash – to show the amount as paid.
Conclusion
Accounting practices regularly encounter accrued expenses while working on their clients’ accounts. However, there was a need to understand these expenses better. This guide aims to simplify accrued expenses and accounting for beginners and accounting practices.
Still, if you find accrued accounting difficult to manage, you can use Corient’s bookkeeping outsourcing services. To learn more about our services or to explain your unique requirements, please contact us via our contact form on our website.