Why Accrued Expenses Need an Adjustment
A business may receive services or use resources before the related invoice arrives or cash is paid. If the reporting period ends in that interval, the expense belongs to the period in which the service was received, not necessarily the period in which payment occurs. An adjusting entry records the expense and the amount owed at the cutoff.
This is an application of accrual accounting and the recognition of expenses when incurred. It is aligned with the SOA VEE Accounting and Finance syllabus. The adjustment is not a cash transaction: it records that the business has consumed a service or resource and has an obligation to pay for it.
For a straightforward accrual, the adjusting entry debits the relevant expense and credits a payable. The debit increases expense; the credit increases liabilities. The exact account title depends on the nature of the cost and the organization’s chart of accounts.
The formula is applied to the cost for the period being reported. If none of the relevant cost has been recorded, the accrual is the full amount incurred by the cutoff. If part is already recorded, only the unrecorded remainder is adjusted. Do not accrue costs for services that will be received after the reporting date.
Determine the Amount at the Cutoff
The essential question is: what has the business received by the end of the period, and what part of that cost is not yet in the accounts? The invoice date and payment date may help provide evidence, but they do not by themselves determine when an expense is incurred.
A practical sequence is to identify the reporting date, establish what service or resource was received by that date, measure its cost using the available agreement or usage information, and subtract any amount already recorded for that same cost. Then record the remaining amount as expense and a liability.
Use the end of the reporting period as the boundary. Include only services or resources received on or before that date.
Use the agreed rate, the amount of service received, a usage reading, or another reasonable basis available at period-end.
Subtract any amount already recorded for the same period and cost. Avoid counting an existing expense or payable a second time.
Debit the appropriate expense and credit a payable for the same amount. Confirm that the entry balances and that cash has not been changed by the adjustment.
Why the Adjusting Entry Has This Form
The debit-and-credit structure follows from what has happened economically. The business has received a service, so the cost belongs in expense for the period. It has not yet paid, so it still has an obligation: a liability. No cash has moved at the adjustment date.
The entry also preserves the accounting equation. Suppose the accrued cost is \(A\). Recording the expense reduces the period’s net income by \(A\), which reduces retained earnings (equity) by \(A\), all else equal. Crediting the payable increases liabilities by \(A\). Assets remain unchanged at the adjustment date. Thus the liability increase is matched by the decrease in equity, and the equation remains balanced.
This is why an accrued expense is not recorded by crediting cash: cash has not yet been paid. When payment later occurs, cash decreases and the payable is cleared. If the earlier accrual is properly included in that settlement entry, the previously recognized expense is not recorded again.
Worked Example: A Service Contract Spanning the Cutoff
A hypothetical business receives cleaning services at an agreed rate of $750 for each five-day workweek, Monday through Friday. The reporting period ends Wednesday. The service provider has not invoiced the business, and no amount for this week has been recorded. Assume the service is provided evenly across the five workdays, the full weekly fee is owed for the week, and there are no taxes or additional charges. Calculate and record the period-end adjustment.
Method: measure the service received through the cutoff. The implied cost per workday is:
Three of the five workdays, Monday through Wednesday, fall in the reporting period. The cost incurred by the cutoff is therefore:
Nothing for this week has already been recorded, so the unrecorded portion is also $450. The adjusting entry at Wednesday’s period-end is:
The adjustment increases the period’s expense and the liability by $450; it does not reduce cash. The two remaining workdays cost \(2 \times \$150=\$300\), which belongs to the next period. If the business later pays the full $750 after Friday, the settlement entry is a debit to Accrued Expenses Payable for $450, a debit to Cleaning Expense for $300, and a credit to Cash for $750. The debits total \(\$450+\$300=\$750\), matching the cash credit.
Check: The adjustment covers exactly three workdays, and the later settlement accounts for all five. The common mistake avoided is accruing the full weekly fee at Wednesday’s cutoff, which would include two days of service not yet received.
Worked Examples
Worked Example: Estimating a Utility Liability From Usage
A hypothetical studio’s reporting period ends on June 30. Its utility meter shows 1,260 kilowatt-hours used during June. The service agreement charges $0.18 per kilowatt-hour plus a fixed monthly service charge of $24. The invoice will arrive in July, and no June utility cost has been recorded. Assume these are the only charges and that all June usage occurred by June 30. Find the expense and liability to accrue.
Method: calculate each component of the incurred cost. The usage charge is:
Add the fixed monthly charge:
Because no June cost has yet been recorded, the full $250.80 is unrecorded. At June 30, record:
The entry recognizes the cost in June and the obligation at June 30. When the July invoice is received, the business should compare it with the amount accrued and account for any difference according to the applicable accounting process; it should not automatically record the entire invoice as a new expense if that would duplicate June usage.
Check: The usage charge plus fixed charge equals $250.80, and the debit equals the credit. The common mistake avoided is accruing only the metered charge and overlooking the fixed charge specified in the agreement.
Worked Example: Updating Period Expense and Net Income
A hypothetical design firm closes its books on September 30. By that date, a consultant has completed four of six service days under a $4,800 fixed-fee engagement. The firm pays after the engagement is complete. No part of this engagement has been recorded by September 30. Before adjustment, the firm’s trial balance shows revenue of $25,000, other expenses of $16,500, and accrued liabilities of $2,400. Assume the fee is earned evenly across the six service days, and ignore taxes and all other adjustments. Find the required accrual, adjusted expense total, income, and accrued liabilities.
Method: allocate the fixed fee by service days completed. The fee per service day is:
Four service days have been completed by September 30, so the fee incurred in the period is:
Because no part of the engagement has been recorded, the adjustment is $3,200. Record a debit to Consulting Expense and a credit to Accrued Expenses Payable for $3,200.
Total expenses before adjustment are $16,500. After adjustment, they are:
Income before adjustment is revenue less expenses:
Income after adjustment is:
Accrued liabilities after adjustment are:
Check: The adjustment lowers income by exactly $3,200 and raises accrued liabilities by exactly $3,200. The two remaining service days, worth \(2 \times \$800=\$1{,}600\), are not included in September’s expense. The common mistake avoided is accruing the full $4,800 engagement fee even though only four of six service days have been completed.
Common Mistakes and Practical Checks
Accruals are often straightforward once the period cutoff is clear. Errors usually arise from confusing the timing of service, invoice, and payment, or from recording a cost already included in the accounts.
- Using the payment date as the expense date. Payment may occur later than the period in which the service was received. Include the cost in the period of receipt when it has been incurred.
- Accruing future service. Do not include work that will be performed after the reporting date. In the cleaning example, only three workdays had occurred by the cutoff.
- Recording the whole contract instead of the amount earned to date. For a service delivered over time, determine the portion received by period-end before calculating the adjustment.
- Recording a cost twice. If some of the cost is already in the expense account, subtract that amount before posting the adjusting entry.
- Crediting cash at the adjustment date. An accrual records an unpaid obligation. Cash is credited only when payment is made.
- Forgetting the liability side. Recognizing expense without the corresponding payable would omit the obligation and leave the entry incomplete.
A final check is to verify that the debit and credit are equal, that the expense relates to services or resources received by the cutoff, and that the payable represents an amount still owed. Then consider the later payment: it settles the liability and reduces cash; it does not justify recording the accrued portion as expense a second time.
Check Your Understanding
For each problem, identify the amount to accrue and the period-end entry. Assume no taxes, no additional charges, and no prior recording unless stated otherwise.
- A business receives equipment-maintenance service at $420 per day from Monday through Friday. Its reporting period ends Wednesday, and no invoice has arrived. What amount is accrued, and what accounts are debited and credited? (Answer: $1,260; debit Maintenance Expense and credit Accrued Expenses Payable.)
- A hypothetical workshop uses 900 cubic meters of water in a month at $0.60 per cubic meter, plus a $35 fixed charge. The month ends before the invoice arrives, and nothing has been recorded. Calculate the accrual. (Answer: $575; debit Water Expense and credit Water Payable.)
- A consultant charges $3,600 for six service days. Four days are completed by the reporting date. The firm has already recorded $900 for this engagement. What additional adjustment is needed? (Answer: $1,500; total incurred is $2,400, less $900 already recorded, so debit the relevant expense and credit a payable for $1,500.)
- A firm has revenue of $18,000 and expenses of $11,200 before adjustment. It owes $2,100 for services received by period-end, none of which is recorded. Find adjusted expenses and income, and state the increase in liabilities. (Answer: adjusted expenses are $13,300, income is $4,700, and liabilities increase by $2,100.)
- A company accrues $680 for services received in December. In January, it pays the $680 with no additional service cost included in that payment. What is the payment entry, and what happens to January expense from this settlement? (Answer: debit Accrued Expenses Payable $680 and credit Cash $680; this settlement records no January expense for the already accrued amount.)