In this video you'll find out what accrued expenses mean
and I'll show you how they work with an example.
[Music]
Hey there
welcome back to Accounting Stuff. I'm James and in this video
we're going to cover accrued expenses in accounting.
This is part of a playlist that I've put together covering
adjusting entries in accounting. Which you can find linked up here
and down below in the description. So far we've covered the
big picture of adjusting entries prepaid expenses
and deferred revenue and very soon I'll be releasing
the final instalment where we'll cover accrued revenue.
So hit subscribe and click on the bell so you don't miss out on that one
and plenty more accounting content that's coming soon.
But in this video we're going to take on accrued expenses with an example.
So let's dive in. In true Accounting Stuff-Style fashion
we'll begin with the definition. An accrued expense is
a past expense that hasn't been recorded or paid for yet.
Let's pause for a moment and think about what this means.
An accrued expense is a past expense that hasn't been
recorded or paid for yet. So this expense will be recorded
or paid out in the future. But right now in the present
we're still waiting for that to happen. Got it?
This will all become clearer with
the example that we'll get into shortly. But first let's think about how
a typical business transaction works. Imagine that we're the buyer and
we want to buy something from someone
the seller. They send us the goods or
provide us with a service and in addition to that
they hand us an invoice. In return we pay them in cash.
Voila!
Transaction complete. With accrued expenses
the seller provides us with the goods or services sometime in the past
but we don't receive the invoice from them
or make the payment to them until later in the future.
Why, why why does all of this matter? Because as financial accountants
we like to use the accrual basis of accounting
and in accrual accounting expenses are recorded as
they are incurred not when cash changes hands.
I like to think of payments as accounting triggers.
When we pay money out of our bank account to a supplier
we code the payment to the relevant account in the general ledger.
Receiving an invoice is also an accounting trigger
when using accounting software like QuickBooks Online you are required
to enter the details from the invoice into your accounts payable ledger
once you've received it. I'll explain how this works later
in the example. OK
Why does all of this matter? My point is that we have two
accounting triggers the invoice and the payment.
If both of these are going to happen later in the future
then right now in the present we've got a problem.
We have no accounting triggers to record the goods or services when
we received them in the past. That's when the substance of
the transaction took place that's when the expense was incurred
and accrual accounting is telling us that we need to record
the transaction here. But how do we go about
accruing an expense in the past. I'll show you right now.
Let's imagine that we own a business and there are some basic overhead costs
associated with running our office. Things like electricity
heating and water. We call these utility expenses
and for now let's focus on water. In our office we are billed for our
water usage on a quarterly basis four times a year
and on each occasion the bill covers our water consumption
for the previous three months. Today is November 1st
the first day of a new billing cycle that means that three months from now
on the 31st of January we'll receive a water bill covering 3 months
November, December and January. Three accounting periods
and to keep things simple let's assume that water
normally costs us about $50 per month. Let's jump forward now to November 30th
one month has passed and it's the end of an accounting period.
Do we have any adjusting entries to post? Yes we do.
We've been using water for a whole month but we haven't received a bill
or paid for any of that consumption yet so we need to accrue an expense
into our general ledger. And how do we do that?
We post a journal entry. We need to recognise a utilities expense
in our income statement. Water normally costs us $50 per month
so we need to increase our utility expenses by $50.
Expenses are the first ‘E’ in DEALER normal debit accounts
so debits increase them and credits decrease them.
Our utility expenses need to go up so we debit our utilities expense
account by $50. But where does the other side
of this transaction go? We are double entry accounting
so there is another side to this adjusting journal entry.
We've already hit expenses in our income statement
so we need to temporarily hold the other side of this journal entry
somewhere in our balance sheet in our accrued expenses account.
But are accrued expenses an asset or a liability?
Let's work it out. Assets bring us future economic benefit
whereas liabilities involve a future economic sacrifice.
We've already received economic benefit from this transaction
because we've been using water for the past month.
But we haven't paid for it yet at the present moment we are
committed to making a future economic sacrifice.
So we have to recognise an accrued expense as a liability
in the balance sheet. Accrued expenses are always
recorded as liabilities in the balance sheet
and liabilities are the ‘L’ in DEALER normal credit accounts
so credits increase accrued expenses and debits decrease them.
So we need to credit our accrued expenses to increase them
by $50 in the balance sheet. Great.
Let's see how this adjusting journal entry affects our general ledger
using T Accounts. We have two T accounts
the utilities expense account in the income statement
and accrued expenses in the balance sheet.
Remember when using T accounts debits always go on the left
and credits always go on the right. We debit the left-hand side
of the utilities expense account by $50 and we credit the right-hand side
of accrued expenses in the balance sheet by $50.
So we have accrued the utilities expense of $50
in our income statement for November. Now let's jump forward to
the end of December. Another month has flown by.
Do we have any more adjusting entries to post?
Yes we do. We've consumed another months worth
of water and we still haven't received a bill or pay for any of it yet.
We need to accrue some more utility expenses.
The journal entry looks like this. It's exactly the same as the one
we posted last month. Why?
Because we estimated that water costs us roughly $50 per month
so we need to recognise another $50 of utility expenses in December
and on the flip side we need to increase our accrued expenses
in the balance sheet by another $50 and how does this impact our books?
Like this. Our utility expenses now come to $100.
50 of which was expensed in November and another 50 in December.
In our balance sheet we are now carrying accrued expenses of $100.
This liability keeps getting bigger because we've now gone two months
without an accounting trigger to settle this once and for all.
We haven't received a bill or a payment in November or December
so we are making our best estimate of what the bill might be at this stage.
Okay now we'll jump forward to the end of January the final month
of our quarterly billing cycle. The water company has sent us
an invoice covering the past three months and it comes to 153 dollars.
So it's not bang on the one hundred and fifty dollars
that we expected but that's okay we used our best estimate
and we actually came in pretty close. Like I mentioned before
I like to think of invoices as accounting triggers.
Here's what I meant by that. When we entered this invoice
into QuickBooks Online or whatever accounting software you're using.
We need to categorise the transaction and when we do this
it automatically triggers a journal entry that gets posted behind the scenes
in our general ledger. If you run a business and receive
lots of invoices. Then this automatic posting
can become a huge time saver and it's one of the many benefits
of using accounting software. I'll pop a link down in the description
to a free trial of QuickBooks Online so you can test it for yourself.
It's an affiliate link so by signing up you'll have the opportunity to
support me making more accounting tutorials just like this one.
The automatic journal entry looks like this.
It debits our utilities expense account by one hundred and fifty three dollars
to increase our expenses. The other side of this journal entry is
going to credit our accounts payable account by one hundred
and fifty three dollars in the balance sheet. I just want to point out at this moment
that we haven't actually paid our water bill yet.
We have only received the bill and now we have 30 days in order
to make the payment. We owe money to the water supplier
so we have a liability in our balance sheet. How does this affect our general ledger?
We need to credit a new t account accounts payable in the balance sheet
by one hundred and fifty three dollars. That's the final balance of what
we owe to the supplier and we debit the utilities expense account
in the income statement by one hundred and fifty three dollars.
But hang on… Our utility expenses are now
two hundred and fifty three dollars that's quite high
our final bill was only one hundred and fifty three dollars.
How does any of this make sense? We accrued fifty dollars
of utility expenses in November and another fifty dollars in December.
When we add the one hundred and fifty three dollars that was
automatically journaled in January we get two hundred and fifty three dollars.
Both our expenses in the income statement and our liabilities in the balance sheet
are overstated by one hundred dollars. That's because we have one more
adjusting journal entry to post. We need to release our
accrued expenses from the balance sheet. So let's do that.
The journal entry looks like this. We need to reduce our
accrued expenses in the balance sheet. Accrued expenses are liabilities
so we reduce them by debiting the account by $100.
Our utilities expense account in our income statement
is also overstated. This is a normal debit account
so to decrease it we credit the utilities expense account by $100.
We post this journal entry into the January accounting period
debiting the left-hand side of accrued expenses in the
balance sheet by $100 and crediting the right-hand side
of the utilities expense account in the income statement by $100.
When we close off the quarter we have incurred utility expenses of
one hundred and fifty three dollars in our income statement.
$50 which we accrued in November another 50 in December
and then in January we took up a further fifty three dollars.
There are no more accrued expenses in our balance sheet
because we released our $100 accrual in January
and we now owe one hundred and fifty three dollars
to our water supplier which we recognise as
a liability in accounts payable. We've recorded all of our expenses
in the correct periods as we incurred them
so our books are in line with the accrual basis of accounting.
In the next video we'll round off this adjusting entries miniseries
with a video on accrued revenue. Click on this circle to subscribe
so you don't miss out on that and the whole playlist
can be found over here. As always if you've got any questions.
Let me know down below in the comments
or message me directly on instagram @accountingstuff
See ya!