Expenses and payables are as inevitable as taxes and duties in this world. And sometimes, they also get just as confusing.
The working capital of any organization is greatly influenced by liabilities—accrued expenses and accounts payable, to be precise. If organizations want to optimize working capital and maintain optimum liquidity for daily operations, managing these liabilities efficiently is paramount.
Let’s dive a bit more into how these two most commonly used financial terms differ and where exactly they overlap.
The costs that a company incurs for purchasing goods and services without making the payment at the time of procurement, and instead, records it and makes the payments later during the current accounting period are called accrued expenses. As the name suggests, accrued expenses are the ones that are accrued or accumulated over time and are recognized as liabilities on the company’s balance sheet.
Note: Regardless of when the payment is made, accrued expenses are recognized in the same accounting period within which the goods or services were procured/received.
A range of obligations falls under the accrued expenses umbrella that companies recognize despite the pending payments.
The short-term debts that a company owes to its creditors for any goods and services purchased are called accounts payable.
Accounts payables come into the picture when a company chooses to receive goods and services on credit and is legally obligated to make all the payments to the vendors and suppliers within the period of time that both the parties (selling and receiving) have agreed upon.
|Accrued Expenses||Accounts Payable|
|Interest on loan||Inventory purchases||Taxes owed||Vendor invoices|
|Employee salaries||Utility bills|
We’d like to present some of the most common examples of accrued expenses and accounts payable to help you understand them better.
- Accrued interest: Interest on the loan that has accrued over the course of time since the time the company borrowed funds
- Accrued taxes: Taxes that are owed for the accounting period and are yet to be paid
- Accrued wages: Employee wages that are to be paid at the end of the accounting period for the service of the employees that was received throughout that period
- Inventory purchases: The amount that is owed under obligation when a company purchases inventory from vendors and suppliers on credit is recorded as “accounts payable” in the books.
- Supplier invoices: The invoice that the supplier raises when a company buys goods on credit, is recorded as “accounts payable” until the payment is processed successfully.
- Utility bills: The pending bills for utilities such as electricity, water, internet connection, gas, etc. billed to the company are recorded as “accounts payable” until they are paid.
While most of us understand what accrued expenses and accounts payable means, it’s common to get confused between the two because of how similar the concepts are on many levels. For instance, both accrued expenses and accounts payable are short-term liabilities recognized under the accrual accounting method; they are derived from accrual basis accounting.
Further, both involve making payments to vendors, suppliers, and service providers. Similarities are also seen in how they impact financial statements and financial ratios.
- Derived from accrual basis accounting
- Identified as current liabilities
- They are payments owed
- They have an impact on free cash flow
The terms start to sound the same after a point and it may be a cause for concern when it comes to segregating expenses on the books. To solve this problem, we’ll be discussing the prominent differences between accrued expenses and accounts payable with some examples.
Even though accrued expenses and accounts payable are financial terms referring to a company’s short-term liabilities, they differ significantly when it comes to the following four factors:
- Recognition of payments
- Impact on financial statement
- Impact on free cash flow
- Schedule of adjustments
Effective decision-making and accurate financial reporting demand a thorough understanding of these key differences.
Recognition of payments
a. Accrued expenses
When a company incurs expenses that build up over time for which the payments are not made immediately, such expenses are recognized as accrued expenses. The recognition for these payments occurs in the same accounting period in which the services, facilities, or goods were received.
b. Accounts payable
When a company incurs expenses on the procurement of services, facilities, or goods on credit, such expenses are recognized as accounts payable. Even though the obligation to process payments for the purchases arises at the time of purchase, the actual payments are made on a later date and terms that have been agreed upon by the selling and purchasing parties.
Impact on financial statement
a. Accrued expenses
As stated before, accrued expenses are recognized as current liabilities and are recorded as the same on the balance sheet under the “current liabilities” section. They are obligations that must be settled within a stipulated amount of time, which generally happens to be a short period. Thus, they are a crucial factor when it comes to assessing the short-term financial obligations of a company.
It’s important to note that an amount recorded as “accrued expense” isn’t a final number. It can change as it is generally an estimate of the amount that has to be paid.
b. Accounts payable
As opposed to accrued expenses, an amount recognized as “accounts payable” is a definite number that has been agreed upon by the selling and purchasing parties.
Just like accrued expenses, accounts payable are recognized as current liabilities and represent the short-term obligations of the company. However, these are listed under the “accounts payable” section and are purposely segregated from accrued expenses. This is done so that the company’s financial position is perceived accurately.
Impact on free cash flow
a. Accrued expenses
Accrued expenses are the dues that have accumulated over time and are yet to be paid. Hence, they do not have an immediate impact on the free cash flow of the company. Having said that, these expenses can definitely affect the net income and profitability of the company.
b. Accounts payable
As accounts payable are short-term debts that are paid off within a specific frame of time, they do have a direct impact on the free cash flow of the company. The company’s cash reserves are immediately affected i.e., they decrease as and when these payments are made. Hence, on the cash flow statement, accounts payable are recorded as a “cash outflow.”
Schedule of adjustments
a. Accrued expenses
Accrued expenses are made and settled at the end of the accounting period in which the purchases were made. This calls for adjusting entries to recognize accrued expenses. Making these entries is crucial to financial reporting by accurately mapping these expenses to the corresponding period in which they were incurred.
b. Accounts payable
Accounts payable are always recorded at the time of purchase. Hence, adjusting entries isn't necessary. Entries, however, may be required when payments are made to ensure that the account’s payable balance is updated and reflects on the cash outflow.
When you think about short-term liabilities, the borders of accrued expenses and accounts payable start melting into each other. Be it the similarities between them or their differences—accountants and businesses cannot afford to miss out on accurately distinguishing the two.
If done incorrectly, the financial reports will paint an unreliable picture. That is how important it is to recognize and segregate these obligations clearly and faultlessly. Besides, one needs to get the recognition timeframe and impact of the expenses on the cash flow right to ensure precise budgeting and financial planning.
Lastly, and we can’t stress this enough, misinterpretation or insufficient understanding of these differences between accrued expenses and accounts payable can reflect an incorrect status of the company’s financial health, leading to poor financial decisions.
Are accrued expenses and accounts payable the same, and can the terms be used interchangeably?
No, they are not the same, and the terms cannot be used interchangeably. Accrued expenses refer to costs incurred by the company on goods or services that have been received, but have pending payments that need to be cleared in the current accounting period. Accounts payable, on the other hand, refer to payments that are recognized at the time of purchase of goods or services, but are deferred to a mutually agreed-upon date by the company and the goods/services provider.
Why is it important to recognize and record accrued expenses accurately in financial reporting?
Recognizing and recording accrued expenses accurately is crucial for accurate financial reporting. Doing so ensures that the expenses are correctly mapped to the revenues that they generate and the timeframe in which the expenses and payments take place.
Is it common practice to reverse accrued expenses in the next accounting period?
Yes, it is okay to reverse or adjust accrued expenses in the next accounting period in case they are not applicable anymore. For instance, when an accrued expense is recorded for a service that wasn’t received, this error can be reversed at the time of settling the payments in the subsequent period.
Are accrued expenses limited to enterprises and large corporations only, or are they applicable to small businesses and SMBs as well?
Accrued expenses, as an accounting principle, are relevant to companies of all sizes, be it enterprises and large corporations, or small businesses and SMBs. Simply put, any business that uses the accrual accounting method will recognize accrued expenses for accurate financial reporting.
Do accrued expenses have an effect on a company's tax liability?
Yes, they can affect a company's tax liability. Since accrued expenses are recognized as expenses, they end up reducing the company's taxable income, and as a result, lower the company’s tax liability. However, accurate recording and management of accrued expenses are vital for compliance and tax planning.
Are companies allowed to avoid recognizing accrued expenses in order to improve their short-term financial performance on paper?
Avoiding the recognition of accrued expenses may artificially inflate the company's short-term financial performance. However, it will certainly result in inaccuracies in financial reporting. Hence, avoiding the recognition of accrued expenses is not a sound financial practice. The way to build trust with the company’s stakeholders and the ability to make informed business decisions is through transparent and accurate financial reporting.
How are accounts payable recorded in the accounting system?
Initially, accounts payable are recorded when a company receives an invoice from a vendor/service provider/supplier for goods or services that are purchased on credit.
Do accounts payable qualify as short-term or long-term liabilities?
Since accounts payable are expected to be settled at an agreed-upon time which generally tends to be within a year or the operating cycle, whichever is longer, they are categorized as short-term liabilities.
Can accounts payable also include interest charges?
Yes. If the company has agreed to pay interest on payments that are overdue while locking in the credit terms with the supplier, then accounts payable can definitely include interest charges.
Can accounts payable affect the credit rating of a company?
Yes, accounts payable can, both negatively and positively, impact a company's credit rating. Timely payments have a positive impact and missed or delayed payments can have a negative impact on the company's relations with the suppliers and creditworthiness.
Is it common for a company to negotiate payment terms with the suppliers?
Yes, companies are absolutely allowed to do that. The negotiations are generally about receiving an extension on the payment period or securing early payment discounts so as to optimize the cash flow.
Can companies strategically leverage accounts payable to manage cash flow?
Yes, companies can be strategic about managing accounts payable for optimizing the cash flow. Companies tend to preserve cash for other business needs by extending payment terms.
Accurate financial management is non-negotiable when it comes to ensuring the success of any business. And a clear and thorough understanding of financial concepts is imperative for building a robust foundation for achieving this success.
Accurate financial reporting, effective cash flow management, informed decision-making, maintaining healthy relations with the vendors, preventing financial mismanagement, tax planning and compliance, and effective management of the company’s working management are some of the critical factors that make understanding the difference between accrued expenses and accounts payable easier. However, the basic and most fundamental reason for doing so is to ensure alignment with compliance with accounting principles.
We hope this article helped you grasp the complicated concepts and highlighted their subtle yet crucial differences.
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