Definition of Accrued Liabilities
Accrued liabilities are those expenses that are incurred by the business but not yet paid. Accrued expense is a part of accrual system of accounting, which states that an expense is recorded when it is incurred, and revenue is recorded when it is earned.
This system of accounting generates more accurate results as the expenses are matched with related revenues and are reported when the expense occurs, not when cash is paid.
Explanation
Accrued liabilities are the actual liabilities, the benefit against which is received by the business, but they are not yet paid. For example, services of the employees have been received, but their salary is yet to be paid, or goods have been received, but payment is yet to be made. Here, payment has to be done in the future period of time. If we don’t record such expenses in our books, it will not reflect a true financial picture of the company’s business. The concept of accrual liabilities occurs only when the business follows the Accrual system of accounting.
An Accrual system of accounting is a system in which all the expenses of a particular period are recorded in the same period in which they are incurred irrespective of the fact whether they are paid or not. Accrued liabilities are not accounted for when the business follows the cash basis of accounting. Under the Cash basis of accounting, only those expenses are accounted for which are paid during that period of time. Accrued liabilities are shown under the current liabilities head in a company’s balance sheet.
How Does an Accrued Liability Work?
Accrued liabilities are recorded in the books of accounts at the end of the accounting period, and they are reversed in the period when they are actually paid. It is like a temporary account created in the books of accounts.
Accounting entry for accrued liability
Expense A/c – Debit (Recording the actual expense)
Accrual Liability A/c – Credit (expense not paid hence liability created)
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Accounting entry when paying accrued liability
Accrual Liability A/c – Debit (Reducing the liability settled)
Cash A/c – Credit (Liability settled by paying cash)
The Accrued liabilities balance in the balance sheet will be reduced after making the payment.
Example of Accrued Liabilities
Suppose Company ABC Ltd. closes its books of accounts on 31 December every year. The company makes salary payment of all of its employees on 5th of next month. So, the salary of December month will be paid on 5th January of next fiscal year, i.e. 2020. December month’s salary to be paid is $50,000.
In this case, the liability to pay the employees has been incurred, but the payment is not yet done. Hence, salary expenses will be recorded, and an opposite accrued liability for the same will be created in the books of accounts, and the same will be reversed next month.
Types of Accrued Liabilities
There are basically two types:
- Recurring accrued liabilities: These are the ones which occur in the normal course of business. For example, wages of the current month paid on 10th of next month.
- Non-recurring accrued liabilities: These are not the regular accrued liabilities and do not occur in the normal course of business. For example, heavy machinery was purchased, but payment was not yet made.
Accrued Liabilities vs Accounts Payable
- The basic difference between accrued liabilities and accounts payable is that the accounts payable is billed to the company, but accrued liability is not yet billed.
- Another difference is that the accounts payable is a liability which will be paid in the near future. On the other hand, accrued liability is generally accrued and paid over a period of time.
- Accounts payable is recorded for any expense which is billed like supplier invoice, vendor payment etc. While accrued liabilities are recorded at the end of the fiscal year.
- For example, a company purchases machinery from a supplier on 30 Dec 2019, the shipment of which will arrive in the next 15 days. If the company receives the invoice on or before the end of the accounting year, it will be booked as accounts payable. If the invoice is not received, it will be booked as an accrued liability.
Advantages
Following are the advantages of recording accrued liabilities:
- Following the accrual system of accounting, it gives a true and fair picture of the company financial position. All the revenues of the current period and the expenses incurred to earn those revenues are recorded in the same accounting period. It will reflect the actual profit/loss of the company.
- The Accrual system of accounting is a preferred system of accounting by the Financial Accounting Standard Board (FASB).
- Financial statements prepared using the accrual system of accounting is more comparable as compared to the cash system of accounting.
Disadvantages
Following are the disadvantages of recording accrued liabilities:
- It is a complex system of accounting and requires competent personnel who can track and report the transaction in a timely manner.
- It does not provide an accurate picture in terms of sales and cash. The company’s sales may be much higher as compared to its actual cash position.
- It does not provide much benefit to small businesses where most of the transactions are done on a cash basis.
Conclusion
Accrued liabilities or accrued expenses are the expenses which are incurred by the business in one period, but the payment will be done in another period. This way of recording the expenses gives us the true picture of accounting.
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