Accrued LiabilityWhat are Accrued Liabilities and How are they Recorded?

Written By:
Adiste Mae

Accounting for your business’s expenses is easy if you happen to pay for them as you incur them.

You just record the expense as debit and credit cash for the same amount.

For example, you went to your regular supplier of office supplies, purchased reams of paper, paid for them, and then recorded the expense in your books.

Easy right? Well, actual expenses don’t always work like that in a business setting.

Sometimes, you incur expenses before you get to pay them.

If incurred expenses were to be paid on the next period, then your financial statements for both periods will be affected.

The income in the period these unpaid expenses were incurred will be overstated due to understated expenses.

On the other hand, the income in the period that these expenses are finally paid will be understated due to overstated expenses.

In short, not reporting expenses when they are incurred can cause inaccuracies in your financial statement.

If there was only a way to record these unpaid expenses huh?

Well, there is.

And it’s called the accrual of expenses.

As you incur expenses, you record them whether they’re paid or unpaid.

If you pay for them as you incur them, no problem.

Just record them as you usually do.

However, if you don’t pay for them as you incur them, then that’s when we accrue expenses.

You debit the expense and credit a corresponding liability account for the same amount.

Depending on the circumstances, the liability account you record might be accounts payable or accrued liabilities.

What is Accrued Liability?

An accrued liability (also referred to as accrued expense) is an expense that has been incurred during a period but is still unpaid by the end of it (period).

Unlike accounts payable, an accrued liability doesn’t come with a corresponding invoice, and as such, is more likely to be an estimation or assumption of incurred expenses.

Accrued liabilities are often recorded at the end of the month when there are still unpaid and unbilled expenses.

For example, you pay your employees their wages every 5th of the month.

That means that the wages they earned from the 6th day until the end of the month won’t be paid until the 5th day of the next month.

To further illustrate, let’s say the wages earned by the employees from 6th until the end of December won’t be paid until the 5th of January of the following year.

That means that the wages expense for December is understated, while it’ll be overstated for January if expenses are recorded only when they are paid.

To remedy this, an accrual must be made.

You debit the total cost of wages from the 6th day until the end of December, and credit accrued liabilities (or wages payable) for the same amount.

That way, the salaries and wages expenses incurred in December will only be recorded in December.

It is important to account for accrued liabilities to provide a more accurate record of your business’s financial health and performance.

It complies with the matching principle, as well as the principle of relevance and timing.

It also helps in accounting for all expenses as not all of them come with a corresponding billing.

This makes it easier to keep track of your unpaid expenses too.

Recording Accrued Liabilities (Cash Accounting Method vs Accrual Accounting Method)

This may not come as a surprise, but recording accrued liabilities is different under the cash accounting method and accrual accounting method.

In fact, under the cash accounting method, you don’t record accrued liabilities at all.

This is because for you to record expenses under the cash accounting method, there must be a corresponding cash payment, something that accrued liabilities don’t have.

And because of that, you won’t be seeing accrued liabilities in the financial statements of businesses that use the cash accounting method.

With that out of the way, the rest of the article will assume that your business is using the accrual accounting method.

Or even if it isn’t, your business is planning to adopt the accrual accounting method, or you just want to learn about accrued liabilities.

To record accrued liabilities, you enter a journal entry in which the debit entry is the unpaid but already incurred expense while the credit entry is accrued liabilities of the same amount.

For example, if you’re rent for the month is still to be paid and billed, you might want to accrue rent expense.

To do so, the journal entry will look like this:

When payment is made for the unpaid rent, the journal entry will be:

In some accounting systems, the journal entry for accrued liabilities is automatically reversed, creating an offsetting entry at the beginning of the next period.

This makes it so that when the expense is paid or when a corresponding invoice is received by the business, the reversed entry cancels out the recording of such expense.

To illustrate, let’s go back to the unpaid rent example above.

Only this time, we’ll assume that the business is using an accounting system that automatically reverses journal entries made for the accrued liabilities.

The journal entry for the accrual of unpaid rent will still be the same:

Then at the beginning of the next period, the reversal entry will be:

And when payment is made for the unpaid rent, the entry will be:

To make the effect of such a system more clear, let’s put amounts.

For example, the amount of unpaid rent to be accrued by the end of February is $400.

So when the journal entry for the accrual of rent is made, rent expense for February will increase by $400:

At the beginning of March, the accounting system will automatically reverse the entry made, which will result in a negative $400 of rent expense:

So when payment is finally made for the accrued rent, the effect on the rent expense account is zeroed out and should only show the rent expense incurred for March:

The issue with such a system is that it may result in negative expenses if the accrued liability is still unpaid and that the corresponding expense is not incurred in the following period.

This issue is much pronounced if the accrued liability is an infrequent or non-routine liability.

Types of Accrued Liabilities

Accrued liabilities can be categorized into two types: routine (or recurring), and non-routine (or infrequent):

Routine or recurring accrued liabilities

As the name suggests, this type of accrued liability corresponds to expenses that a business regularly incurs during its operations.

As such, they are predictable and easy to make estimations of. Some expenses that may fall under this category are the following:

• Salaries and wages that are not paid by the end of the period
• Accrued rent expense
• Interest on financial obligations that are still to be paid
• Supplies expense that wasn’t paid and billed for by the end of the period

Basically, any regular expenses that are still to be paid by the end of the month.

For example, if salaries and wages are paid every 5th and 20th of the month, then the wages for the 21st day until the end of the month will remain unpaid until the 5th day of the next month.

An accrual must be made to record the cost of these unpaid salaries and wages.

And since it happens every month, it is a routine accrued liability.

Non-routine or infrequent accrued liabilities

Accrued liabilities that all under this category correspond to unpaid expenses that a business does not regularly incur or expect.

For example, you have a supplier from who you regularly purchase merchandise.

You receive the billing and make payments at the same time you receive the merchandise.

However, on the last day of June, you received merchandise from this supplier without a corresponding billing/invoice.

You tried to contact your supplier but you can’t reach them.

Since you couldn’t make payment without the billing, you decided to estimate the amount of merchandise you received and record a corresponding accrued liability.

The recorded accrued liability is considered a non-routine accrued liability.

Unlike routine accrued liabilities, non-routine accrued liabilities are hard to predict and may mess up your projected cash flow.

Be extra mindful of potential non-routine accrued liabilities as they might negatively affect your business’s liquidity.

Are accrued liabilities: current or non-current liabilities?

Accrued liabilities are generally current liabilities.

This is because you usually pay them in the following period.

For example, accrued liabilities that correspond to unpaid salaries and wages will have to be paid on a certain day of the following month.

Not doing so might cause your employees to protest.

Another example would be accrued interest.

You will have to pay the accrued interest by next month to avoid penalties.

Prepaid Expenses VS Accrued Liabilities/Expense

Prepaid expenses refer to payments for expenses that are still to be incurred.

For example, if your business paid for a whole year’s worth of rent in advance, then a corresponding prepaid expense is recorded.

Rent expense is not yet recorded as it is not consumed or incurred yet.

At the end of the month, an adjusting entry will be entered into your book’s journal to record a month’s worth of rent expense, while the credit entry will be a reduction in prepaid expenses by the same amount.

While both are balance sheet items, “prepaid expenses” is an asset account, which is different from “accrued liabilities/expenses” which is a liability account.

Prepaid expenses are recorded when payment is made before expenses are incurred.

On the other hand, accrued liabilities/expenses are recorded when expenses are incurred before payment is made.

In short, prepaid expenses are paid for in advance, while accrued liabilities/expenses are still to be paid for.

Do Accrued Liabilities affect cash flow?

Short answer: Yes, but indirectly.

Accrued liabilities affect cash flow in that they postpone the outflow of cash for the payment of certain expenses.

The effect is typically temporary as accrued liabilities will eventually have to be paid for.

Under the indirect method of preparing a cash flow statement, any increase in accrued liabilities will result in an increase in the net cash flow.

Likewise, any decrease in accrued liabilities will decrease the net cash flow.

Accrued Liabilities vs Accounts Payable

Both “accrued liabilities” and “accounts payable” are liability accounts.

They both generally correspond to short-term expenses which makes them current liabilities.

And that’s where their similarities end.

The main difference between “accrued liabilities” and “accounts payable” is their relationship with billings.

Where account payables correspond to billed (but unpaid) expenses, accrued liabilities do not.

As such, accrued liabilities do not come with billing statements.

For example, the purchases you make in credit usually come with billings/invoices which makes the corresponding liability an accounts payable. On the other hand, salaries and wages don’t often come with billings, and as such, the corresponding liability will be an accrued liability.

Accrued liabilities are often estimations of the amount of expense, while accounts payable represent the exact amount of expenses to be paid (which is stated on the billing statement).

For example, you purchased materials on credit.

You received said materials, however, you have yet to receive a billing statement.

It is the end of the month, and still no billing statement.

So you recorded an accrual equal to your estimation of the amount of materials received.

On the 7th day of the following, you finally received the billing statement.

You the debit the accrued liability you recorded (if it wasn’t reversed), and then credit accounts payable for the amount stated on the billing statement.

If there’s a difference (e.g. estimate is lower than exact amount), then the balance will either be a debit or credit entry to the materials account.

Examples of Accrued Liabilities

The following are some of the common examples of accrued liabilities:

• Salaried and wages that are unpaid at the end of the month
• Fringe benefits and other benefits that are unpaid at the end of the month
• Services that have already been performed and received but the service provider is yet to bill the business
• Products that are already received but the billing statement has not been sent by the supplier
• Interest on loans that are yet to be paid by the end of the month
• Utilities expense incurred during the month but is still to be billed and paid