Key Points
- An accrued expense appears as a current liability because the entity has consumed the benefit but not yet received or paid the invoice.
- The accrual basis under IAS 1.27 requires recognition when the economic event occurs, not when cash changes hands.
- Understating accruals at year-end directly overstates profit; a missed €200,000 utility accrual drops straight to the bottom line.
- Accrued expenses are reversed or settled in the next period when the actual invoice arrives and payment is made.
What is Accrued Expenses?
IAS 1.27 requires financial statements to be prepared on the accrual basis (except for cash flow information). When an entity receives goods or consumes services before the invoice arrives, it records an accrued expense to ensure the cost hits the correct period. The entry debits the relevant expense account and credits a current liability (often labelled "accruals" or "accrued liabilities" on the statement of financial position).
The amount recognised is management's best estimate of the obligation at the reporting date. For some accruals (unbilled electricity, for instance), the estimate is straightforward because the consumption is metered. For others (professional fees partly incurred, bonuses tied to year-end targets), the estimate requires judgment. The auditor evaluates whether the estimation method and inputs are reasonable under ISA 540.13(a), paying particular attention to completeness. Missing accruals are harder to detect than overstated ones because they leave no audit trail in the purchase ledger. ISA 500.A14 reminds auditors that testing for completeness often requires procedures different from those used for occurrence, and accounts payable confirmations or post-period invoice reviews are the standard tools.
Worked example
Client: German engineering company, FY2025, revenue €28M, HGB reporter (with IFRS-aligned accrual policies). Hoffmann closes its books on 31 December 2025. Four accruals require recognition.
Step 1 — Identify unbilled obligations at 31 December
Hoffmann's finance team reviews open purchase orders, service contracts with period-based billing, and employee benefit calculations. Four items surface: (a) €38,000 in unbilled legal fees for an ongoing patent dispute, (b) €14,200 in electricity consumed in December but billed quarterly in January, (c) €91,500 in employee bonuses earned under the 2025 incentive plan but payable in February 2026, and (d) €6,800 in audit fees for interim work performed in November.
Documentation note: record each accrual source, the contract or consumption evidence, and the basis for including each item per IAS 1.27. For HGB, §252(1) Nr. 5 HGB mirrors the accrual requirement.
Step 2 — Estimate the amounts
Legal fees are based on the external counsel's estimate of hours worked but not yet billed (142 hours at €268/hour). Electricity is estimated from meter readings and the contracted per-kWh rate. Bonuses are calculated from the board-approved incentive plan, applying actual FY2025 revenue and EBITDA against the plan thresholds. Audit fees are per the engagement letter's interim billing schedule.
Documentation note: for each accrual, record the estimation method, the source of the inputs (counsel letter, meter reading, board resolution, engagement letter), and the calculation. Reference ISA 540.13(a) for the auditor's evaluation of the estimation approach.
Step 3 — Record the adjusting entries
Debit legal expense €38,000 / credit accrued liabilities €38,000. Debit utility expense €14,200 / credit accrued liabilities €14,200. Debit staff costs €91,500 / credit accrued liabilities €91,500. Debit audit fee expense €6,800 / credit accrued liabilities €6,800. Total accrued liabilities recognised: €150,500.
Documentation note: record the journal entries with posting references. Classify all four as current liabilities (settlement expected within 12 months). Cross-reference to the accruals listing maintained by the entity.
Step 4 — Test completeness
The auditor performs a post-period invoice review, examining invoices received in January and February 2026 for services delivered before 31 December 2025. Two additional invoices totalling €4,300 (cleaning services and IT support) relate to December but were not accrued. The auditor evaluates whether the omission is material against performance materiality.
Documentation note: document the post-period invoice sample, the cut-off date applied, the two exceptions identified, and the conclusion on materiality. Reference ISA 500.A14 for completeness testing procedures.
Conclusion: the accruals of €150,500 are defensible because each estimate traces to an external source document, and the post-period review identified only €4,300 in unrecorded items (below the €12,000 clearly trivial threshold set at planning).
Why it matters in practice
- Completeness of accruals is the most common year-end finding on non-Big 4 engagements. The FRC's 2021/22 Audit Quality Inspection report noted that auditors frequently rely on management's accruals listing without performing independent completeness procedures such as post-period invoice reviews or analytical comparisons to prior-year accruals. ISA 500.A14 distinguishes occurrence testing from completeness testing, and a search of unrecorded liabilities requires looking outside the recorded population.
- Teams often apply a blanket reversal approach, reversing all prior-year accruals in the opening period without checking whether the original estimates were accurate. IAS 8.32 requires changes in accounting estimates to be recognised prospectively, and material over- or under-accruals from the prior year should be investigated rather than silently absorbed into the current period's expense lines.
Accrued expenses vs [prepaid expenses](/glossary/prepaid-expenses)
| Dimension | Accrued expenses | Prepaid expenses |
|---|---|---|
| Timing of cash vs benefit | Benefit consumed before cash is paid | Cash paid before benefit is consumed |
| Balance sheet classification | Current liability | Current asset |
| Direction of misstatement risk | Understated accruals overstate profit | Understated prepayments overstate expenses |
| Period-end action | Recognise a liability for the unpaid cost | Recognise an asset for the unused portion of the payment |
| Common examples | Unbilled utilities, earned but unpaid bonuses | Insurance premiums paid annually, rent paid in advance |
The distinction matters on every engagement because both are cut-off issues. An accrual omitted at year-end pushes an expense into the next period. A prepayment not deferred does the opposite, pulling a future-period cost into the current year. Auditors test both through cut-off procedures under ISA 500, but the direction of the test differs: for accruals, look for unrecorded liabilities; for prepayments, look for costs that should have been deferred.
Related terms
Frequently asked questions
How do I test accrued expenses during the audit?
Perform a search for unrecorded liabilities by reviewing invoices received after the reporting date, examining open purchase orders at year-end, and comparing the current accruals listing to the prior year's actual invoices received. ISA 500.A14 requires the auditor to design procedures that address completeness separately from occurrence, because a missing accrual leaves no entry in the ledger to sample from.
What happens if accrued expenses are not recorded at year-end?
Omitting an accrual understates liabilities and overstates profit in the period. If the omission exceeds performance materiality, the auditor adds it to the summary of unadjusted misstatements and requests correction. ISA 450.5 requires the auditor to accumulate identified misstatements, and an uncorrected accrual flows into the evaluation of whether the financial statements as a whole are materially misstated.
Do accrued expenses apply to interim financial statements?
Yes. IAS 34.28 requires interim financial reports to apply the same accounting policies as annual statements, including the accrual basis. An entity that skips accruals at half-year and catches up at year-end misstates both the interim and annual results, because the expense belongs in the period when the service was consumed.