Accrued cost and its application in business
Companies often incur expenses and record them in their book of accounts as they occur, even though the payment has not been made for that product or service. Such expenses are called accrued costs.
Accrued costs are not used in companies that operate under the cash method of accounting. Instead, the cash basis of accounting identifies entities when paid, but the accrual method recognises accrued expenses/costs based on when service is accomplished or received.
Companies making use of the accrual method of accounting identify accrued costs as costs or expenses that are yet to be paid for but have already been incurred.
The accounting of accrued expense journal entries is based on the double-entry system, which means while one account is debited, another is credited. The accrued costs are debited from the suitable expense account and credited to an accrued liability account.
Next, a second (reverse) journal entry is prepared in the following period to reverse this entry. It improves the accounting system’s accuracy, thus making things easier during audits.
The accrued cost incurred by a company is recorded in the accounting period in which it was incurred and before it has been paid. Since accrued costs imply a company's commitment to making payments in future, they are shown as current liabilities on the balance sheet.
The accrued cost/expense may be a rough estimate and often differs from the supplier's invoice, which arrives later.
Suppose an employee of a particular company purchases supplies for an event in January, for which he will be reimbursed on his February paycheck. With the accrual method, the expenses show up on the company’s income statement in January as the employee purchases the supplies, whereas the actual reimbursement happens the following month.
A few other examples of accrued costs/expenses are- A company purchases supplies from a vendor but is yet to receive an invoice.
Payment for Interest on loans, taxes incurred by a company, etc., but no invoices were generated, or payments were made. Employee wages, bonuses, and commissions are accrued when they occur, and the actual payment is made in the following period.
In cash basis accounting, all transactions and financial events are recorded only when there is a cash transaction or exchange. This method of accounting may result in the misstatement of income and account balances.
Whereas the accrual method of accounting recognises revenue when earned and expenses when incurred (but not paid) and provides a comprehensive picture. It helps to better understand a company's current financial health and predict its future financial position.
Although this method is labour-intensive due to extensive journaling needs, it is a more accurate measure of a company's transactions and events for each period.
Prepaid expenses are represented as assets on the balance sheet. Here, companies pay in advance for all products and services that are expected or to be utilised later.
But, accrued expenses represent liabilities. Here, expenses, when incurred, are not paid, and the company makes cash payments in future.
Accounts payable are short-term debts for goods or services for which invoices have been received, but payment is yet to be made.
However, accrued costs are expenses a company has incurred but cannot pay as it has not received invoices. The company accounts for these costs so that the management knows its total liabilities and allows the company to make better decisions on its spending.
On a company's balance sheet, accrued expenses and accounts payable are considered current liabilities.
For most businesses, except those cash-rich ones that run entirely on cash payments (for revenue and expenses), the accrual method of accounting is ideal as it gives a more accurate picture of a company's overall financial health.
It is a preferred method of accounting because it offers a more precise representation of a company’s finances, and the business looks more stable and improves the chances of receiving funding.
A few other benefits of using accrued costs are:
- As using accrued costs makes the relationships between revenue and expenses more transparent, companies can get a better insight into profitability, making it easier to plan and strategise.
- It usually produces more consistent financial results as companies can include recurring transactions yet to be paid in their financial reports.
- Also, accrued costs/expenses might be a mandatory financial reporting requirement for certain companies and their SEC (Securities and Exchange Commission) filing conditions.
The accrual method of accounting makes financial statements more consistent by recording charges in specific periods. Moreover, product-based businesses with inventory usually benefit from this method of accounting because other methods don't correctly account for COCS (cost of goods sold) and lower the gross profit.
While applying the accrual method of accounting for your business, you must take a few precautions. Since this method of accounting is more time-consuming, there is a chance of misstatements if auto-reversing journal entries are not correctly used. Also, a company might also accidentally accrue an expense it has already paid.
By embracing these necessary measures, the accrual method of accounting will yield a more accurate picture of the company's transactions and events for each period and avoid misrepresenting its income & account balances.