Accrued Expenses

Under accrual accounting, a company records an expense when it consumes a benefit, regardless of when it pays. If employees work the last two weeks of December but get their paycheck in January, the company still earned the value of that labor in December — so it records a wage expense and an offsetting 'accrued wages' liability at year-end. When the cash is finally paid in January, the liability is reduced and cash goes down; no new expense hits the income statement. This matching of expense to the period of consumption is what makes the income statement economically meaningful rather than a record of cash movements.

Both are current liabilities representing unpaid obligations, and they're easy to confuse. The distinction: accounts payable arises when a vendor sends an invoice for goods or services already delivered — there's a specific bill on file. Accrued expenses are typically obligations the company knows it owes but for which no invoice exists yet, so the amount is often estimated. Accrued wages, accrued interest, and accrued income taxes are classic accruals. Accounts payable, by contrast, is the supplier invoice for inventory or services. In modeling, both are working-capital liabilities, but AP is usually tied to COGS while accruals tie to operating expenses and financing costs.

Accrued expenses are a working capital item, and changes in them flow through the operating section of the cash flow statement. An INCREASE in accrued expenses is a source of cash: the company recorded the expense (reducing net income) but hasn't actually paid it, so you add the increase back. A DECREASE is a use of cash: the company is paying down obligations it previously accrued. This is why a growing company often shows operating cash flow above net income — it's accruing expenses faster than it pays them, effectively a free short-term financing source.

These two are mirror images and interviewers love to test the difference. An accrued expense is incurred but NOT yet paid (liability) — you got the benefit, you owe the cash. A prepaid expense is paid but NOT yet incurred (asset) — you paid the cash, you're owed the benefit. Prepaid insurance is the classic example: you pay $1,200 upfront for a year of coverage, record a $1,200 prepaid asset, then expense $100 each month as you consume it. Accrued and prepaid are the two adjusting-entry concepts that make accrual accounting work, and knowing both cold separates strong candidates from weak ones.