When we begin to talk about "accrued" items in relation to accounting transactions, we begin to go further into the reporting side of accounting, and in order to keep this article as simple as possible, we're not going to expand on the relationship of accrued items to balance sheets, profit and loss sheets, etc. We're simply going to define what an accrued expense is, and how you would record such an item.
Accrued expense refers to an expense that has been incurred but not yet paid. Examples of accrued expense items might be interest that has accrued on an outstanding note that has not been paid, and taxes that have accrued but not yet been paid.
One of the most basic concepts of accounting involves determining if an item is an asset or a liability. Unpaid payroll expenses, unpaid interest on notes, and taxes incurred but not yet paid are liabilities. Although not yet paid, they must be accounted for within the company's financial records. Thus, the entries of "accrued" expense were born.
Let's take a situation of unpaid but accrued interest expense on a note, and try to explain why it's important to record any unpaid liabilities on the company's balance sheets. Suppose Company B owes Central Bank a loan in the amount of $5000. The note is a 12 month demand note (this means no monthly payment, just one lump sum payment of note plus interest is due in 12 months. Okay, Company B owes the bank $5000 plus interest at the end of 12 months. The interest rate on the note is 20%; now, in reality this is pretty high, but we're using this to illustrate a point. So, at the end of the year, or 12 months, Company B is going to owe Central Bank $6000.
Now, suppose you're in charge of expenses budgeting for Company B and you have the budget down to within a few hundred dollars, and your bonus at the end of the year increases for every month that you're within budget. You are not familiar with accounting procedure that covers accrued expenses, but why should you worry, nothing seems to be "accruing" during the months you've been monitoring expense items. All is well.
Until, the 12th month arrives. Suddenly, your budget is blown away by the lack of proper accounting procedure. You failed to account for the accruing of interest on the $5000 note. Now, you're budget is over by $1000. No bonus for you!
This method of accounting for "accrued" expenses is not utilized by many of the small businesses in operation today; however, it is one of the biggest reasons for business failure today: a lack of anticipated expense, especially in the area of fixed expense.
As you begin to study and learn about accrued expenses and deferred expenses, whether you operate a business, or a household budget, the necessity of understanding and accounting for those silently "accruing" expenses, will often mean the difference between operating within your budget, and begin over budget, and this sometimes equates to being over drawn as well!
Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.