Among many important judgment and decision that accounting people often take on daily basis, is whether to or not to accrue an expense. For some people, it may be an easy decision. But for many others, such decision could be tricky—in considering the consequences that come along the decision.
An accounting staff of my client, last week, asked me about whether she should or should not accrue an expense.
The answer could be as short as YES/NO; or as lengthy as a book chapter, but I would rather give some hindsight—so that she really understands the matter in question, in-and-out. That way, I can avoid the possibility of answering the same question in the future—and save my own time. So, should or shouldn’t you accrue an expense? What expense should/shouldn’t you accrue? Why? Read on…
In short words, accruing an expense means, recognizing an expense before it is actually ready to be recognized or have not even happened yet. There are two main purposes for accruing an expense: (1) allocating expenses in monthly basis; and (2) speeding up month-end closing.
Each of the two purposes need different degree of consideration whether to or not accrue an expense. Let’s discuss it one-by-one. Read on…
1. Allocating Expenses in Monthly Basis
Some expenses typically occur once in a year, and are usually in big amount. Rather than recognizing the expenses at once (in certain month,) it would be more appropriate if they are allocated to each of the twelve month instead, so that the monthly statement reflect the revenue-expense matching.
The decision whether to or not to accrue such expenses are quiet straightforward:
- Certainty of the occurrence – As long as the occurrence of the expenses is certain, you can accrue them on monthly basis.
- Certainty of the timing – You are able to accrue an expense on monthly basis only if you know (or can estimate) about when the expense will be occurring, otherwise you aren’t.
- Certainty of the amount – As long as you can estimate the amount of the expense by using the previous occurrence, you can accrue it by using the estimated amount.
Most common examples of such expense are:
- Bonuses – Rather than waiting until bonuses are fully earned and payable to recognize them, you can accrue some proportion of bonuses in each reporting period if there is a reasonable expectation that they will be earned and that the eventual amount of the bonuses can be approximately determined.
- Vacation Hours Earned – You can accrue for vacation hours earned, but only if they are already earned as of the end of the reporting period. For example, if your company awards vacation hours to its employees at a constant hourly rate that adds up to two weeks per year, then you would accrue the difference between the amount accrued to date and the amount taken in actual vacation hours. However, if there is a “use it or lose it” limitation that restricts the number of vacation hours that can be carried forward into future periods, then the accrual is limited to the maximum of this carry forward amount.
- Sick time – The amount of sick time allowed to employees is usually so small that there is no discernible impact on the financial statements if they are accrued or not. This is particularly true if unused sick time cannot be carried forward into future years as an ongoing residual employee benefit that may be paid out at some future date. If these restrictions are not the case, then the accounting treatment of sick time is the same as for vacation above.
- Property taxes – You may be notified well in advance by the local government authorities of the exact amount of property tax that will be payable on a later date. Since property taxes do not vary much from year to year, you can easily record a monthly property tax accrual, and adjust it slightly when the exact amount payable becomes known.
2. Speeding Up Month-End Closing
The amount of expenses often can be known only after the month-end closing. Rather than waiting for the exact amount and postponing the month-end closing, you may consider accruing the expense, instead. But, the decision whether to accrue an expense—just for this purpose—is a little bit tricky.
While you can speed the month-end closing up, there are consequences that come along with the decision. The most important factor one should consider, before deciding to or not to accrue an expense—solely for the purpose of speeding up the month-end closing–is: the worthiness of accruing an expense. Ask yourself with this:
“Is this expense worth accruing?”
Considering worthiness of accruing an expense means, you are scaling-up the ‘cost-and-benefit’ of doing it. Here are two factors you should consider:
(a) Journalizing it Once Vs Twice – While it does, actually, speeds month-end closing up, accruing an expense means you’re ready for double-work. Let’s say the electric bills can only be known after the month-end session. So, rather than postponing the month-end closing until you get the exact amount of the bill, you use an estimate amount to accrue it instead, and eventually close the book. Using the previous income statement, you estimate current electric expense of $3,200.00. So you would make the following entry, at the month-end closing:
[Debit]. Electric Expense = $3,200.00
[Credit]. Accrued – Electric Expense = $3,200.00
Few days later, you receive the actual bill with actual amount of $3,000.000. As you see that you’ve overstated the electric expense, you would make a correction entry for it and wash the accrual account at the same time with the following entry:
[Debit]. Accrued – Electric Expense = $3,200.00
[Credit]. Accounts Payable = $3,000.00
[Credit]. Retained Earning = $200.00
That said, accruing an expense means you’re ready to journalize it twice, instead of once. The decision whether to or not to accrue an expense, and what expense you should accrue—based on this factor, most likely depends on the availability of your time subsequent the month-end closing. Just make sure the balance of accrual accounts do not stay too long after the actual amounts becomes known. So, before deciding whether to or not to accrue an expense, you may want to ask yourself with this:
- “Do I have enough time for double work? What can I bear?”
- “Will I remember to make a correction entry?”
- “Will I remember to zero-in the accrual accounts?”
(b) Timeliness Vs Quality of the Financial Statement – Even if you have plenty of time subsequent month-end closing—so that you’re always ready for such double work, there are other factors—which is even more important than the previous factor, you would need to consider: timeliness vs quality of the financial statement.
The decision whether to accrue or not to accrue an expense means you’re choosing between timeliness and quality of financial statement that expected to be delivered to the management and other users. And, this is uneasy decision, indeed—even for those who have been around in the accounting fields for years.
In one side, you’re expected to complete and submit financial statements on time, but in other side you’re also expected to deliver accurate numbers on it. As shown on the above example, you use an estimation to determine the amount of the expense, instead of the actual amount.
By accruing some expenses, you can fasten the month-end closing process—and complete financial statement earlier but you’re, actually, compromising accuracy of numbers presented o the statements. It could be in within acceptable for the internal user (management of the company), but it is absolutely unacceptable for external users—including the shareholders.