Accrued expenses

Accruals ensure expenses are recorded in the correct accounting period. This chapter explains how to adjust for costs incurred but unpaid, including the related journal entries, reversals, and the impact on financial statements under the matching principle.

Learning objectives

By the end of this chapter, you should be able to:

• Apply accrual accounting to accrued expenses.
• Calculate the adjustments needed for accrued expenses when preparing financial statements.
• Illustrate the process of adjusting for accrued expenses when preparing financial statements.
• Prepare manual journal entries and update the general ledger accounts for the creation and reversal of accrued expenses.
• Identify the impact of accrued expenses on profit and net assets.
• Report accrued expenses in the financial statements.

The accrual and matching concepts

These fundamental principles state that, when determining profit, expenses incurred (whether paid or unpaid) should be matched against the revenues earned (whether received or not) in the same accounting period.

In other words, financial statements should reflect the economic substance of business activities by aligning related revenues and expenses within the appropriate reporting period.

The matching concept ensures that related revenues and expenses are recorded in the same period to provide an accurate measure of performance, regardless of the timing of cash flows.

Definitions

Adjustment

In practice, because business operations continue throughout the year, during an accounting period, a business entity may:

1. Accrued expenses: Receive goods/services from suppliers, but invoices have not yet been received by period-end.
2. Prepayments: Make advance payments to suppliers for goods/services to be supplied in the subsequent period.
3. Deferred income: Receive payments from customers for goods/services to be delivered in the subsequent period.
4. Accrued income: Supply goods/services to customers but invoices not yet issued by period-end.

All these events, when they occur, need to be adjusted so they are reported in the correct accounting period.

Accruals

Definitions

Accruals

Also known as accrued expenses. These are expenses that have been incurred during an accounting period for goods delivered or services rendered by a supplier, but for which the invoice has not yet been received as at the end of the accounting period.

Once the invoice is received, the amount owed is a trade payable, not an accrual.

Because of the matching concept, you record the expense in the period it relates to, even if the invoice hasn’t arrived yet. Since the exact amount may be unknown at period-end, the business estimates the amount expected to be invoiced by the supplier.

That estimated amount is recorded as:

• an expense (because the cost relates to the current period), and
• a liability (because payment is still outstanding).

The liability is called an accrual (or accrued expense) and is reported under current liabilities; the debit increases the relevant expense in the statement of profit or loss.

Journal entry

The accrued expenses, when computed, are recorded in the general ledger using the journal entry:

Debit: [Relevant] expense (e.g. electricity expense)

Credit: Accruals (current liability)

Recording an accrual increases expenses, so profit falls; it increases current liabilities, so net assets fall by the same amount. Failing to accrue overstates both profit and net assets.

Reversal of accruals

The accrual recorded at the end of the period is an estimate of the supplier’s invoice. In the next period, it’s dealt with in three steps:

1. At the year end, set up the closing accrual: debit the expense and credit accruals, as above.

2. At the start of the next period, bring the accrual down as an opening balance on the credit side of the expense account. This reverses it:

   Debit: Accruals

   Credit: Expense

3. When the invoice arrives, record it in full, like any other invoice. The amount owed is now a trade payable:

   Debit: Expense

   Credit: Trade payables (or Bank, when it’s paid)

The opening credit and the full invoice net off, so only the difference between the invoice and the estimate is left in the new period’s expense. You don’t need a separate entry for the difference. If the estimate was too low, the shortfall adds to the new period’s expense; if it was too high, the excess reduces it. The previous period’s figures aren’t changed.

So the expense charged for the year is:

$$\text{Expense for the year}=\text{Paid}-\text{Opening accrual}+\text{Closing accrual}$$

Example: Expense ledger account

Dagona Limited pays for its telephone service in arrears. At January 1, 2025, the accrual brought forward for telephone expense was $300. During 2025, the company paid $3,900 in cash for telephone bills. The final invoice of the year, received in February 2026, was for $900 and covered the three months November 2025 to January 2026.

Because the accounting period ends on December 31, only two of those three months (November and December) relate to 2025, so the closing accrual is time-apportioned: $\$900\times \frac{2}{3}=\$600$.

Telephone expense account	$		$
Bank (cash paid)	3,900	Balance b/d (opening accrual)	300
Balance c/d (closing accrual)	600	Profit or loss (balancing figure)	4,200
Total	4,500	Total	4,500

The opening accrual of $300 sits on the credit side because it is 2024’s bill, already charged in 2024. Part of the $3,900 paid in 2025 settles it, so the credit takes it back out of 2025’s charge.

Answer: the profit or loss charge for 2025 is cash paid plus the closing accrual minus the opening accrual: $3,900 + $600 − $300 = $4,200. The closing accrual of $600 is reported as a current liability at December 31, 2025.

Illustrations: walkthrough

Dagona Limited prepares its financial statements annually on December 31st. The company receives electricity bills quarterly, with invoices arriving approximately one month after the quarter ends.

On December 31, 2024, Dagona Limited had not yet received the electricity bill for the quarter October-December 2024. Based on previous quarters and usage patterns, the accountant estimated the electricity expense and recorded an accrual of $4,500.

In January 2025, Dagona Limited received the actual electricity invoices for the October-December 2024 quarter from three different facilities:

• Facility A: Actual invoice = $1,800 (Accrued amount: $1,800)
• Facility B: Actual invoice = $2,000 (Accrued amount: $1,700)
• Facility C: Actual invoice = $600 (Accrued amount: $1,000)

Required:

1. What is the initial accrual journal entry recorded on December 31, 2024?

2. What entry is made on January 1, 2025, to reverse the accrual?

3. The three invoices are received in January 2025. What entry records them, and how do they compare with the accrual?

4. What is the net effect of the reversal and the invoices on the 2025 electricity expense?