Accrued Expenses: Explained
The extremely precise world of accounting can be bewildering to grasp for an entrepreneur who has the broader strategy in mind. As an SMB, you may be spending lots of time working endlessly on your product, preparing your pitch deck and chasing your customers.
While the books may not be on top of your mind right now, putting on the bookkeeper’s hat to get your accounting method sorted out as early as possible in your business can mean immense benefits for your business moving forward. Some of these include being able to accurately track your business’ financial health and providing reliable forecasts for potential investors to determine your sustainability and profit potential.
So, it does not always imply an a-cruel world. In this article, we address what accrued expenses are and how they work to make your accounting simpler and easier.
What are Accrued Expenses?
Accrued expenses refer to payments for goods and services that have been delivered, and not necessarily paid. “Accrued” implies accumulating. For this type of expense account, they are accumulated in the balance sheet for that period as they occur, although the actual payments can be made at a later date.
Some examples of accrued expenses include:
- Unpaid bills in the form of rent, utilities and taxes incurred but not billed until the end of the accounting period
- Wages incurred but payments not made to employees yet
- Interest payables (e.g. loan interest) not paid off for the period when the loan is used
While accrued expenses represent liabilities, prepaid expenses on the flipside are recorded as assets in the financial statement for the current period. Prepaid expense will only be credited in the subsequent period(s) when the goods and services are being used.
Some examples of prepaid expenses include:
- Corporate insurance policy premiums paid before policy year begins
- Subscriptions or membership fees paid that begin in the next year
- Advance travel payments such as flight tickets and hotel accommodation for business trips
What is Accrual Accounting?
The main difference between the cash basis and the accrual method of accounting is in the timing when the revenue and expenses get recognized.
With cash basis accounting, the transaction gets recorded as soon as physical cash/cheque gets in or out of the hand. With the accrual basis of accounting, we look at anticipated revenue and expenses based on the goods and services that are delivered and used. There is the expectation that money/cheque will be paid in the future.
Here’s a snapshot of the rules of the thumb for both accounting methods:
|When is it recognized in the financial statement?||Cash basis accounting||Accrual accounting|
|Revenue recognized||When cash/cheque is received from the customer.||When revenue is earned.|
|Expense recognized||When cash/cheque is paid out to the supplier.||When an expense is incurred.|
An example of a software subscription business adopting a cash basis vs. accrual accounting method is as follow:
With cash basis accounting: If the client pays the total amount for a 3-year subscription before it starts, it would have been all recorded in the first financial period and nothing for the following periods. This could lead to vastly different numbers in two consecutive periods.
With accrual accounting: The timing of when a client pays for their subscription does not affect the business’ financial records. The revenue would have spread over the length of the client’s subscription to balance out the transaction.
The timing of the reporting ultimately implicates the profits reflected from one reporting period to the next. Henceforth, choosing the accounting method is an especially important decision for SMBs requiring their financial health to be in top shape when presenting the reports to the investors.
Here are some pros and cons of adopting the accrual accounting method:
|More accurate portrayal of highs and lows throughout the financial period → Better equipped to do long-term strategy and resource planning.||Complicated rules of recognising revenue and expenses, so require more time and resources that SMBs may not have to spare.|
|Unaffected by cash timing in business negotiations → More representative of a company’s financial status.||Due to confusion with this method, more susceptible to fraud and deception.|
|Compliant with GAAP, which is key when a business expands to outside investors and Singapore Financial Reporting Standards (SFRS).||Difficult to switch from cash basis to accrual accounting, than the other way round.|
The matching principle in Accrual Accounting
This accrual concept of accounting states that all expenses and revenue have to be matched as much as possible in the net income statement for the reporting period. Where the expenses and revenues are justified against each other, investors get a better sense of the economics and operations of the business.
However, it’s not always a smooth, direct cause-and-effect with expenses and revenue. For example, investments made in human capital, improving productivity and marketing may not have a clear return on investments (ROIs) or that it may take a longer time to reap benefits. Although that is the case, these expenses would still have to be accounted for during the period where the investments are made.
How will Accrual Accounting affect my cash flows and taxes?
Since the transaction and cash haven’t yet exchanged hands, the accrual accounting method poses an additional layer of work to find out your cash flows at a given point in time (e.g. examining your account receivables and payables). In this regard, the other method may be better positioned to allow you immediate access to cash flow visibility with very minimal effort (e.g. merely checking your bank account balances).
Tax-wise, income is recorded when you earned it in the accrual method, whereas the cash basis method allows you to consider income only when you have received it. In Singapore, businesses who adopt the cash basis method would have to apply with the Inland Revenue Authority of Singapore (IRAS)’s Cash Accounting Scheme which enables businesses to account for output tax only when payment is received.
What is the difference between accruals and accounts payables?
Accounts payables are only one of the many expenses that fall under the accruals category. By definition, accounts payables are short-term debts that must be paid off by the end of the year. However, both of them are regarded as liability accounts, specifically current liabilities that will be paid soon.
For better clarity of the differences, here’s a snapshot of the two:
|Accrual Expenses||Accounts Payables|
|Balance Sheet||Reflected on the income statement (reports revenues and expenses for a given period – typically a fiscal quarter/year).||Reflected on the balance sheet (reports assets and liabilities at a specific point of time).|
|Occurrence||Includes other monthly recurring expenses like rent, employee wages and loan repayments. Pro-tip: Keep in mind the “accumulating” definition of accrual.||Usually deals with expenditures related to business operations (i.e. goods or services that the business needs to keep running). Pro-tip: The business would have received invoices in this regard.|
|Creditor’s Profile||Most often payable to either employees or banks.||Payable to creditors.|
Get started by speaking with us at Spenmo on how to best track your expenses with our App! And find out more about how Spenmo integrates with other accounting software for accounting reconciliation >>>
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