Accrued expenses: definition, explanation, examples and entries

Definition:

Accrued expense is an expense that is incurred but not paid.

Explanation:

It is a good practice for companies to know their profitability every month. This helps companies to plan their road to success. To know your monthly profit/loss you need to book the income and all the cost/expenses associated with that particular month. Expenses paid through cash/bank and expenses that is payable for the month.

Example:

Let us say, you own a coffee shop and you would like to know the profit/loss your coffee shop has made in July.2015.

Today is the 29th of Aug.2015! Lets see what you have made for the previous month.

Let us assume that you know the actual sales your café has made in Jul.2015. On the expense side, you have paid employee’s salaries in CASH on the 25th of Jul.2015. So what is your profit/loss for Jul.2015?

Income            : 15,000

Expense

Salaries           : (5,000)

Profit               : 10,000

Is that your profit really? Well, salaries are the only expense you paid in cash. But like I said earlier, in accrual accounting concept, all the expenses that are incurred but not paid also adds up to your expense list. Everything that you are ‘supposed’ to pay is your expense too.

Let us assume you have incurred the following expenses in July.2015:

Rent for July: Paid in Aug
Telephone expense for July: Paid in Aug
Water bill for July: Paid in Aug
Electricity bill for July: Paid in Aug
Interest on loan from the bank for July: Paid in Aug

 

Now let us see your profit/loss for July:

Income Sales for the month    15,000.00
Less: Expense
Salaries   5,000
Rent   4,000
Telephone exp          10
Water bill          25
Electricity bill          40
Bank Interest   1,000 (10,075)
Profit for July        4,925

 

Did you see the difference? Accrual concept gives you a close-to-accurate result for the month/accounting period.

Accrued expense entry:

Dr … expenses a/c (Rent/telephone/water/electricity/interest account)

Cr….Accrued expenses a/c

When accrued expenses are actually paid (in any months that follow), the entry can be:

Dr….Accrued expenses (exact amount as accrued.)

Dr…expense a/c (if you have accrued a lesser amount, the balance goes here)

Cr…Cash/Bank

Or

Reverse accruals and the post payment entry:

Cr…expenses a/c (reversal of accruals)

Dr…Accrued expenses

 

AND the second entry: Payment entry

Dr…Expense a/c

Cr…Cash/Bank

Let’s try this with numbers from the example shown above:

Scenario A

METHOD 1:

In July.2015 accrued entry for rent will be:

Dr…Shop rent a/c = 4,000

Cr…Accrued expenses a/c = (4,000)

(With this entry you have taken rent (4,000) into consideration to know your profit/loss status for July)

Let us assume you paid the rent in August: Entry in Aug.2015 will be:
Dr…Accrued expenses a/c = 4,000

Cr…Shop rent a/c = (4,000)

(With this REVERSE entry you have cancelled the previous entry posted in July. This will not change your July profit/loss. Your July books are already closed)

Again in Aug, your second entry will be:

Dr…shop rent a/c (July rent paid)= 4,000/-

Cr…Cash/Bank = 4,000

(This is your payment entry against provision (accrual) you had made in July. Like so, your shop rent a/c will have no effect in Aug and you are now ready to make a new provision for Aug.)

In case, you haven’t yet paid the rent for July and have no intention to pay it until Dec.2015 you mustn’t reverse the entry. Leave that 4,000 in your accrued expense a/c. This is because you need to pay your rent sooner or later. Whenever you pay, reverse the accrual entry and pass a cash/bank entry.

 

METHOD 2:

In July.2015 accrued entry for rent will be:

Dr…Shop rent a/c = 4,000

Cr…Accrued expenses a/c = (4,000)

Let us assume you paid the rent in August: Entry in Aug.2015 will be:
Dr…Accrued expenses a/c = 4,000

Cr…Cash/Bank a/c = (4,000)

(See the difference? Instead of the reversal entry we directly credited cash/bank a/c. This will have the same effect as the entry shown in method1)

 

Scenario B

Let us assume your land lord has become greedy seeing your business grow and he now demands 4,500 instead of 4,000 that you used to pay previously. But you had not the slightest clue of this change! You have accrued only for 4,000. Let us see the entry by using METHOD 2

In July.2015 accrued entry for rent will be:

Dr…Shop rent a/c = 4,000

Cr…Accrued expenses a/c = (4,000)

Let us assume you paid the rent in August with an increased amount of 500: Entry in Aug.2015 will be:

Dr…Accrued expenses a/c = 4,000 (against provision made in July)

Dr…Shop rent a/c = 500 (Add excess paid to rent a/c as rent a/c is short by 500)

Cr…Cash/Bank a/c = 4,500 (paid through cash/bank)

Well, your profit for July is down by 500. But this change will be reflected in your Aug.2015 profit/loss report. In any case, your July books are already closed and mustn’t be touched. Since you have paid and posted the payment entry in August, hence forth beware of this new change and make provisions accordingly.

In some cases, July books are re opened to post one additional accrued entry for 500. Don’t post cash/bank entry in July. This is because you have already closed your cash/bank accounts for July and reconciled the balances with physical cash and bank balance. Consult with your Finance Manager before re-opening a closed book.

Good luck!

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