If you’re like most business owners, you didn’t start a company because you love looking at financial statements.
But, as the owner, you’re responsible for understanding financial statements and using them to make decisions that help you stay afloat and grow.
One of the basic insights financial statements provide is how much it costs to run your business.
On the surface, operating expenses might seem straightforward, but sometimes aren’t billed to you in time to get them in the books for a certain accounting period. When that happens, you can use the accrued liabilities accounting category to estimate the bills you haven’t paid yet.
Keep reading to learn how accrued liabilities differ from expenses and how to use and interpret them on your financial statements.
Accrued Liabilities
Accrued liabilities (also called accrued expenses) are expenses that have been incurred but not paid.
For example, if you haven’t received a phone bill but your accounting period has ended, you’ll need to estimate the amount incurred up to that date.
The accrued liability comes from accrual basis accounting, which the U.S. GAAP (Generally Accepted Accounting Principles) requires for most businesses, though some businesses like sole proprietorships are permitted to use cash basis accounting.
Under accrual accounting, you have to record your revenues and expenses as they’re earned or incurred, not when they’re received or paid in cash.
Say you expect your phone bill to arrive on Jan. 15, but your accounting period ends on Dec. 31. Under the accrual method, you’ll estimate how much of the phone bill you owe by that Dec. 31 date (based on previous invoices).
Since you won’t pay the expense right away, the amount will be accrued (accumulated) towards your phone expense. It will appear under current liabilities on your balance sheet because it needs to be paid in the short-term (within the next 12 months).
Examples of Accrued Liability
There are two types of accrued liabilities: routine and non-routine. Routine accrued liabilities come from your business's regular expenses such as rent and wages. Non-routine liabilities, on the other hand, come from non-ordinary expenses or one-time purchases.
For example, say you place a one-time order with a supplier and receive the goods, but they don't send the bill right away. This liability is non-routine because this is a one-time infrequent purchase, and it's accrued because you haven't received the bill yet.
The following are some examples of routine accrued liabilities.
- Accrued interest: Interest is charged periodically—monthly, quarterly, or annually—on the outstanding amount. So you need to calculate the accrued interest expense at the end of each accounting period and credit it to your accrued liability account.
- Accrued rent: Office or warehouse rent accrues periodically and becomes an accrued liability until paid.
- Accrued wages: Any wages that will be paid at the start of the next accounting period must be classified as an accrued liability on the balance sheet for the current accounting period.
Other examples of accrued liabilities are accrued payroll taxes and warranty costs, which are considered routine.
Accrued Liabilities vs. Expenses
All accrued liabilities are expenses, but not all expenses are accrued liabilities. Once you’ve paid off a liability, it’s no longer accrued. You can also pay an expense as soon as it’s due, so it never becomes an accrued liability.
Consider the phone bill again. Say your accounting period still ends on Dec. 31, but you receive your phone bill on Dec. 31 and pay it the same day. The amount you paid will still be recorded as an expense on your income statement, but since you’ve paid the bill, it’s no longer an accrued liability.
Expenses paid directly show up on the cash flow statement, while unpaid expenses become an accrued liability.
Accrued Liabilities vs. Accounts Payable
Accrued liabilities and accounts payable both deal with your business’s unpaid expenses, but they have a slight difference.
Specifically, your accrued liabilities include all unpaid expenses for which an invoice (or bill from your vendor) has not been received. Once you receive an invoice from a vendor, that expense moves from accrued liabilities into accounts payable.
Why does the invoice matter?
Before you receive the invoice, you may not have the exact expense amount. You’ll most likely have to estimate it. So your accrued liabilities account represents estimated unpaid expenses, but the expenses in your accounts payable are exact amounts.
Accrued Liabilities and Financial Statements
There are three primary financial statements that help you understand your business activity and financial position. They are the income statement, balance sheet, and cash flow statement.
Let’s look at how your accrued liabilities may appear on each statement using the first example: You need to prepare your financial statements on Dec. 31. And while your phone service uses a monthly billing cycle—which covered Dec. 1 to 31—it doesn’t send out the bill until Jan. 15.
Income Statement
The income statement calculates your net income by using the following formula:
Net Income = Revenue – Expenses
Since you’re preparing the income statement on Dec. 31 before your phone bill arrives, you’ll have to estimate that particular expense.
Remember, this is because the accrual accounting method requires you to record your expenses as they arise, not as you pay them.
Since you’ve been using the phone service in December, you need to record the expenses on your Dec. 31 income statement even if you don’t receive your bill or pay for the service until Jan. 15.
If your company pays close to $500 each month for phone service, you can use that as your estimated phone expense on the income statement.
You’ll record a $500 accrued liability under expenses, which reduces your net income by $500. If you don’t account for accrued liabilities on the income statement, you may end up overestimating your net income.
Balance Sheet
On the balance sheet, your accrued expenses are listed in the liabilities section under current liabilities. Typically, there’s a line item called “Accounts Payable and Accrued Liabilities,” which represents all of your business’s unpaid expenses for that accounting period.
In our example, the phone bill would account for $500 of current liabilities on the balance sheet.
Cash Flow Statement
Your cash flow statement starts with net income (which you calculated on the income statement) and then adjusts based on the cash that actually entered and left your business accounts.
Remember, on the income statement, the estimated $500 phone expense was recorded as an expense and reduced your net income by $500.
However, since the expense is unpaid, that money hasn’t actually left your cash account as of Dec. 31, which means you need to make an adjustment. To do so, you’ll record $500 on the Accrued Liabilities line item in the Cash Flow from Operations section.
Your accrued liability is a positive value on the cash flow statement since it represents the money still in your accounts. In contrast, the accrued expense is a negative value on the income statement because it represents incurred expenses during the accounting period.
Accrued Liabilities Aren’t Always Bad News
The term “accrued liabilities” may make it seem like your business is taking on more debt. But this method of accounting is just a tool used in accrual-based accounting to help you better understand your business expenses.
Accrued liabilities account for your expenses even if they're billed much later, so you have a more accurate picture of how much it costs to do business at the end of every accounting period.
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