3. Accrued expenses (accrued liabilities)
Accrued expenses (also called accrued liabilities ) represent unpaid and unrecorded costs incurred in the current period. Accrued expenses should be recognized before cash is paid and should be reported in the income statement in the period they are incurred, and not in the period they are settled (e.g. paid with cash).
Accrued expenses or liabilities are shown under the current liabilities in the balance sheet. To record accrued expenses, a company debits (increases) an expense account and credits (increases) a liability account. These adjusting journal entries recognize expenses incurred but not yet paid (i.e. obligation or liability). If the company does not make such an adjusting entry, expenses (in the income statement) as well as current liabilities (in the balance sheet) will be understated, while equity will be overstated, as the result.
Examples of accrued liabilities are wages, taxes, rent, and interest. For instance, to record accrued liabilities, companies credit the following accounts: Accounts Payable, Insurance Payable, Interest Payable, Legal Fees Payable, Office Salaries Payable, Rent Payable, Salaries Payable, Wages Payable, Accrued Payroll Payable, Income Taxes Payable, State Unemployment Taxes Payable, Employee Federal Income Taxes Payable, FICA Taxes Payable, etc.
Accrued Expenses Example
At the end of a period, companies often have accrued interest on long-term liabilities (e.g. bonds payable, notes payable).
When such interest is paid (i.e. Cash is credited) on the last day of an accounting period, there is no need for an adjusting entry. However, companies have to accrue interest expense from the most recent payment date to the end of an accounting period if the next payment will be in the next accounting period. The basic formula for calculating interest expense is:
I = P x R x T
where I is the interest expense (dollar amount); P is the principal amount of the loan; R is the annual interest rate; and T is the time or fraction of the year from last payment until end of the accounting period.
For example, Friends Company, a manufacturer of valves, has a $120,000 loan from a bank at 10% annual interest rate. The interest on the loan is paid semiannually on July 1 and January 1. Thus, the semiannual interest rate is 5% (10% ÷ 2), and the company pays $6,000 ($120,000 x 5%) on July 1 and January 1.
From January 1 to February 1, the company incurs interest expense, but it does not pay it with cash until July 1. Nevertheless, Friends Company has to record the incurred interest expense and accrued liability for the month of January. The company should make the following adjusting entry: