Accounts Payable vs. Accrued Expenses: Understanding the Differences and Proper Accounting Practices

As a financial professional, it's crucial to have a solid understanding of the differences between accounts payable and accrued expenses. These two concepts are often confused, but they play a vital role in accurately recording and reporting a company's financial transactions. In this comprehensive blog post, we'll dive deep into the definitions, characteristics, and proper accounting practices for both accounts payable and accrued expenses, using real-life examples to illustrate the key points.

Accounts Payable: The Basics

Accounts payable are amounts recorded from vendor invoices for goods and services. When a company purchases goods or services from a supplier, it receives an invoice from the vendor. This invoice represents a liability that the company must pay, typically within a specified time frame, such as 15 or 30 days. The company then records this liability as an accounts payable on its balance sheet.

The process of recording and paying accounts payable is part of the larger "procure-to-pay" cycle, which is covered in detail in the Controller Academy online course. This cycle includes the steps of purchasing goods or services, receiving the invoice, approving the invoice, and ultimately making the payment to the vendor.

Accrued Expenses: Understanding the Concept

Accrued expenses, on the other hand, are obligations to pay in the near future. The term "accrued" means to accumulate or increase over time. Accrued expenses represent costs that a company has incurred but has not yet paid for or received an invoice for. These expenses must be recorded to comply with the accrual basis of accounting, which is the standard accounting method required by the Generally Accepted Accounting Principles (GAAP).

Accrued expenses, also known as accrued liabilities, are essential for accurately reporting a company's financial position and performance. By recording these obligations, the company ensures that its financial statements reflect the true economic reality of its operations, rather than just the cash transactions that have occurred.

Locating Accounts Payable and Accrued Expenses on the Financial Statements

• Both accounts payable and accrued expenses are typically classified as current liabilities on the balance sheet, as they represent obligations that are expected to be paid within the next 12 months. However, in some cases, accrued expenses may be considered long-term liabilities if the obligation extends beyond one year.

Understanding the placement of these items on the financial statements is crucial for analyzing a company's financial health and performance.

Accounting for Accounts Payable

Let's walk through an example of how to record an accounts payable transaction in the accounting software, using QuickBooks Online as our reference.

Suppose that your company, Spa Booker, has received an invoice from 1-2-3 Dig Marketing Inc. for monthly public relations services from March 2022 to February 2023, totaling $122,000 plus $12,960 in sales tax. To record this accounts payable transaction, you would follow these steps:

• Log in to QuickBooks Online and click on "New" under the "Vendors" section.

• Select "Bill" and choose the vendor, 1-2-3 Dig Marketing Inc., from the list (or create a new vendor if it doesn't exist).

• Enter the bill number (134), the description of the services ("PR service"), and the total amount ($134,960).

• Assign the expense to the appropriate category, in this case, "Prepaid Expenses" since the invoice covers a full year of service.

• Select the relevant class, which in this example would be "Sales & Marketing".

• Click "Save" to record the accounts payable transaction in the system.

This process of recording the vendor invoice and creating an accounts payable entry completes the first step in the procure-to-pay cycle. The next step would be to make the actual payment to the vendor, which would then clear the accounts payable balance.

Accounting for Accrued Expenses

Accrued expenses are recorded as part of the month-end close process, after the accounts payable have been closed. Let's explore an example of how to account for accrued vacation expenses, which is a common type of accrued liability.

Spa Booker, our example company, offers its employees 20 days of paid time off (PTO) per year. At the end of each month, the company needs to record an accrual for the vacation time that has been earned by employees but not yet taken.

To calculate the vacation accrual, Spa Booker follows these steps:

• Obtain a report from the payroll provider that shows the outstanding vacation balance for each employee as of the end of the month.

• Review the report and gather the necessary information, such as employee name, department, hourly rate, and vacation balance in hours.

• Calculate the total vacation liability by multiplying the vacation balance in hours by the employee's hourly rate for each employee.

• Summarize the vacation liability by department, using a SUMIF formula in Excel to group the amounts.

• Record the month-end journal entry to debit the vacation expense and credit the accrued vacation liability, with the expense allocated to the appropriate departments.

You can download the vacation accrual example spreadsheet to see how this process is implemented in detail.

In the following month, when updating the vacation accrual, you would only record the difference between the current month's balance and the previous month's balance. This ensures that the liability is accurately reflected on the balance sheet without double-counting the expense.

The journal entry to record the vacation accrual in QuickBooks Online would consist of multiple debit lines for the vacation expense, allocated to the relevant departments, and a single credit line for the accrued vacation liability. This way, the expense is properly recognized, and the liability is accurately reported on the balance sheet.

Common Types of Accrued Expenses

In addition to vacation accruals, there are several other common types of accrued expenses that companies need to consider during the month-end close process:

• Vendor Invoices Received but Not Approved: These are invoices that have been received from vendors but have not yet been approved for payment, often due to missing information or the need for additional approvals.

• Vendor Invoices Not Received: These are expenses for goods or services that have been received or rendered, but the company has not yet received an invoice from the vendor.

• Compensation Accruals: These include accruals for payroll, bonuses, and other employee-related expenses that have been earned but not yet paid.

Properly identifying and recording these types of accrued expenses is crucial for ensuring the accuracy of a company's financial statements and compliance with GAAP.

The Importance of Distinguishing Accounts Payable and Accrued Expenses

Accurately differentiating between accounts payable and accrued expenses is essential for several reasons:

• Financial Reporting Accuracy: Properly recording these liabilities ensures that a company's financial statements, such as the balance sheet and income statement, accurately reflect the company's financial position and performance.

• Compliance with GAAP: Accrual-based accounting, which includes the recognition of accrued expenses, is the standard required by GAAP. Failing to record accrued expenses would result in non-compliance with these accounting standards.

• Investor and Stakeholder Confidence: Investors and other stakeholders rely on a company's financial statements to make informed decisions. Accurate reporting of accounts payable and accrued expenses contributes to the overall transparency and credibility of the company's financial information.

• Cash Flow Management: Understanding the distinction between accounts payable and accrued expenses helps companies manage their cash flow more effectively, as they can anticipate and plan for upcoming payments.

By mastering the concepts of accounts payable and accrued expenses, financial professionals can ensure that their companies maintain accurate financial records, comply with accounting standards, and provide stakeholders with reliable and transparent financial information.

Conclusion

In this comprehensive blog post, we've explored the key differences between accounts payable and accrued expenses, their importance in financial reporting, and the proper accounting practices for recording these liabilities. By understanding these concepts and applying them consistently, financial professionals can contribute to the overall financial health and transparency of their organizations.

Remember, if you're interested in further expanding your knowledge on these topics and other essential controller skills, be sure to check out the Controller Academy online course. Additionally, you can download the month-end close checklist and the vacation accrual example spreadsheet to assist you in your day-to-day accounting tasks.

If you have any questions or topics you'd like me to cover in a future video, feel free to leave a comment below. I'm always eager to address the concerns and interests of my audience.