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!