Here's the rule. If a company incurred, used, or consumed all or part of an expense, that expense or part of it should be properly recognized even if it has not yet been paid. If such has not been recognized, then an adjusting entry is necessary.
Accrued expense refers to an expense that the company has not paid yet but it has already incurred.
At the end of period, accountants should make sure that they are properly recorded in the books of the company as expense, with a corresponding payable.
Dr Expense account
Cr Payable account
The pro-forma adjusting entry to record an accrued expense is:
*Appropriate expense account (such as Utilities Expense, Rent Expense, Interest Expense, etc.)
**Appropriate liability (Utilities Payable, Rent Payable, Interest Payable, Accounts Payable, etc.)
For the month of December 2020, Gray Electronic Repair Services used a total of $1,800 worth of electricity and water. The company received the bills on January 10, 2021. When should the expense be recorded, December 2020 or January 2021?
Answer – in December 2020. According to the accrual concept of accounting, expenses are recognized when incurred regardless of when paid. The amount above pertains to utilities used in December. Therefore, if no entry was made for it in December then an adjusting entry is necessary.
In the adjusting entry above, Utilities Expense is debited to recognize the expense and Utilities Payable to record a liability since the amount is yet to be paid.
Here are some more examples.
Example 1: VIRON Company entered into a rental agreement to use the premises of DON's building. The agreement states that VIRON will pay monthly rentals of $1,500. The lease started on December 1, 2020. On December 31 of the same year, the rent for the month has not yet been paid and no record for rent expense was made.
In this case, VIRON Company already incurred (consumed/used) the expense. Even if it has not yet been paid, it should be recorded as an expense. The necessary adjusting entry would be:
Example 2: VIRON Company borrowed $6,000 at 12% interest on August 1, 2020. The amount will be paid after 1 year. At the end of December, the end of the accounting period, no entry was entered in the journal to take up the interest.
Let's analyze the above transaction.
VIRON will be paying $6,000 principal plus $720 interest after a year. The $720 interest covers 1 year. At the end of December, a part of that is already incurred, i.e. $720 x 5/12 or $300. That pertains to interest for 5 months, from August 1 to December 31. The adjusting entry would be:
Expenses are recognized when incurred regardless of when paid. What you need to remember here is this: when it has been consumed or used and no entry was made to record the expense, then there is a need for an adjusting entry.