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 (or issued but unpaid) 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 (or payment has not yet been made) as at the end of the accounting period.

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 expense is described as accrued expenses, while the related liability is described as accrued payable. Together, they are referred to as accruals.

Definitions

Accruals: Journal Entries

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

Debit: Accrued expense

Credit: Accrued payable

The accrued expense is charged to the statement of profit or loss. In contrast, the liability (accrued payable) is presented as a current liability on the face of the statement of financial position.

Reversal of accruals

The accrued expense recorded at the end of the accounting period is an estimate of the supplier’s invoice amount. In the subsequent accounting period, when the actual invoice is received, it may be equal, higher, or lower than the accrued expense.

Definitions

1. Where the actual invoice amount is equal to the accrued expense. No adjustment of the initial journal entry for the accrued expenses would be required.
2. Where the actual invoice amount is higher than the accrued expense. This means the initial accrued expense has been understated, so both the expense and the liability must both be increased by the amount difference.

The journal entry, both with the amount difference, would be:

Debit: Expense Credit: Accrued payable

3. The actual invoice amount is lower than** the accrued expense. This means the initial accrued expense has been** overstated **, so both the expense and the liability must both be decreased by the difference. The journal entry to pass the difference would be:

   Debit: Accrued payable

   Credit: Expense

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, ABC 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, ABC 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? Do you know the answer?

2. For each facility, identify whether the accrual was equal to actuals, understated, or overstated. Do you know the answer?

3. Calculate the total actual electricity expense for the quarter and compare it to the accrued amount. What is the net difference? Do you know the answer?

4. Prepare the net adjustment journal entry if the company prefers to record one combined adjustment for all facilities. Do you know the answer?