The Thing About Cash Versus Accrual Accounting
We can’t address how accrued expenses fit into the bigger picture of your business, without an explanation of cash versus accrual accounting methods. For a deep dive into accounting methods, refer to our article on “Do You Need a Bookkeeper or an Accountant?,” but here’s our quick run down. In cash basis accounting, income is recorded when cash is received and expenses are recorded when cash is spent. However, this simple “cash in cash out” record doesn’t always paint a true reality of what is happening in your business – enter accrual accounting.
The significance of accrual accounting can best be explained through the example of an insurance policy which will also help us explain accrued expenses. Let’s assume for easy math that Simple Startup’s insurance policy costs $12K for one year of coverage. With the cash accounting method, the entire $12K expense would be recorded in January. BUT in the accrual accounting method, the $12K expense would be recorded throughout the year. So instead of the $12K expense listed in January, a $1K prepaid expense would be recorded for each month of the year.
Why Should You Care?
So why is it important to understand cash versus accrual accounting to understand how accrued expenses fit into your business?
Accrual accounting helps you see what is truly happening in your business as it matches revenue and expenses to when services are delivered / received, NOT when cash changes hands. This has a BIG impact on the presentation of your financial statements and ultimately allows you to see the patterns in profitability that otherwise would be unclear when using the cash accounting methodology.
Accrual (or GAAP) based accounting is the foundation for managing all aspects of your books well, and it is very hard to wrap your head around accrued expenses without it. We totally get that this could sound confusing, after all Mozart didn’t compose his first sonata in one sitting, so if you don’t feel you have a good understanding, please start by reading one of our earlier blogs discussing the difference between a bookkeeper vs. an accountant.
So, with your knowledge of cash vs. accrual accounting on lock, what are accrued expenses?
What Are Accrued Expenses?
Accrued expenses, which are sometimes referred to as accrued liabilities, are debts a business accumulates for services or goods that have already been received but have not yet been billed. To articulate this in layman’s terms, since we pride ourselves on helping entrepreneurs simplify their finances, let’s work through an example.
Assume your company has hired a lawyer that will be completing a host of legal aid for your business to help you complete a round of funding. The lawyer has explained that they will not be billing you for their services until the capital raise has been completed in 4-6 months time. If you engage your lawyer in July and you close your funding round in December, then you will have received 6 months of legal services before receiving a tangible bill. But, obviously, that doesn’t mean you haven’t been accumulating legal expenses for the duration of those 6 months!
As a business owner, you know that when you’re receiving services, even if the lawyer isn’t invoicing for those services, that should not stop you from recognizing the expenses – accrued expenses – on your books. The point we’re trying to underline is that the last thing you would want to happen is for a bill from your lawyer to come through for $150K (to be surprised by that bill) and for the entire bill to be recorded in the month it was received. The outcome of the entire bill being recorded in one month would skew your company’s profitability, muddying the clarity you would have been able to reach, if the expense was spread out over the time period the service was being delivered.
Expenses In an Ideal World
Ideally your lawyer from the above example would be sending a statement outlining an hourly rate and the number of hours performed each month, so that we know the actual dollar amount of the accrued expenses. The ideal scenario, though, is often not the case, which means you will have to estimate each month’s accrued expenses, potentially based off of prior services or verbal estimates from your lawyer. This estimate will then allow you to flatten the expense curve over the time period the service was received.
The bottom line here is to understand that accrued expenses are another way of capturing business expenses without there being a cash record (or even a bill received) but not letting that stop you from creating highly accurate financial records, which is the jumping off point for so many good things in business.
Two Common Examples of Accrued Expenses
Let’s work through two more accrued expense examples to see how they could potentially come into play within your own business to further clarify how proper expense recording can create a clearer picture of your business’s financials.
Interest Incurred on Loans
For business owners who have used the PPP Loan through the SBA, this example is for you! The terms of the Payroll Protection Program loan is to accrue interest and defer principal payments for 6 months. To properly depict this interest as an expense on your books, you will need to record (and accrue) interest for each of the 6 months which avoids all of the interest being captured (cash basis) in the month the interest falls due.
This way of capturing your accrued interest expenses allows you to keep a really clean and consistent financial picture that will help provide you with better insight to ultimately make informed decisions for your business. This better insight can only come from knowing your ACCURATE numbers and the actual cash fluctuations occurring in your business (not JUST how external parties choose to bill you).
The Case of the Missing Invoices
Knowing the expenses that should and should not be on your books is pretty important, right? Right. So let’s look at a unique use for recording accrued expenses that keeps surprises at bay – something our team recently experienced as well. Simple Startup has been using a new software platform that helps us keep our inbox organized (so important!), but realized due to an invoicing error we had not yet received an invoice for a few months of service. This could potentially have left us surprised (AND frustrated) when a big bill cropped up down the road.
BUT since we are super type A about our internal books, we had already included a monthly accrual to account for this. If we hadn’t noticed this vendor error and had not already been accounting for the software service as an accrued expense, that invoice could have had a BIG negative impact on our profitability when the vendor finally sends us a bill to catch up for all those missing months.
The All-Important Supporting Schedule
You may have noticed us mention a new term, supporting schedule, just a paragraph ago? Are you wondering what a supporting schedule is? Supporting schedules are like monthly planners for accountants. They help accountants keep track of account expenses in order to perform monthly reconciliation activities. They’re essentially supplementary tables of data that not only back up the numbers on your income statement and balance sheet (accurately) but also help make sense of your business’s chart of accounts, accrued expense journal entries, and ensure an organized financial statement at the end of each month (clarity and transparency). If you’re not already keeping track of account data in a supporting schedule, we highly recommend it for your sanity’s sake and the sake of your books!
When Does Accounts Payable Come Into the Picture?
You now have a clear picture of accrued expenses, but you’re probably wondering where do accounts payable come into the picture? Aren’t they expenses too? The main difference between accrued expenses and accounts payable is that an invoice has been received for the latter. Put simply, if you have received a bill from a vendor then that is Accounts Payable however, if you have not received a bill and you know services have been received, this is an Accrued Expense.
It’s Time to Take the Bull by the Horns
Entrepreneurs are shot callers, they’re not afraid to take the bull by the horns! And since this is the case, it would also stand to reason that they wouldn’t let their vendors call the shots when it comes to expense tracking. It’s time to take your expense records by the horns and manage your accrued expenses (a supporting schedule will help!). When your records are kept clean (accrual accounting), you can see clear trends in profitability helping you to plan better for the future of your business. I know that YOU know that accrual accounting is the RIGHT path forward, but maybe you’re having a tough time getting a jump start on things. Don’t worry, give Simple Startup a call and we’ll share the same Supporting Schedule we use to keep our own books squeaky clean!