The Comprehensive Guide on How to Read a Financial Report: Wringing Vital Signs Out of the Numbers, + Website

CHAPTER 11

ACCRUING LIABILITIES FOR INCURRED BUT UNPAID EXPENSES

Understanding Hidden Risks with This Connection

Chapter 10 is dedicated to understanding the connection between known operating expenses and accounts payable. That is, when a vendor or supplier presents an invoice to a company for payment (for inventory, operating expenses, etc.), the invoice is processed and recorded directly into accounts payable. This chapter dives into the much more “subjective” concept of accruing liabilities for incurred but unpaid expenses. For some incurred but unpaid expenses, there really isn’t much subjectivity present as the expense can be easily quantified and calculated to determine within a high degree of reason what the final expense will be.

A perfect example of this is based on commission expense for sales representatives who are paid when cash payment for the trade receivable is actually received. For example, if $2,000,000 of trade receivables are outstanding at the end of the month and a company pays a 5 percent commission to the sales representatives when final payment from the customer is received, a total of $100,000 of accrued commission expense would be present and recorded as an accrued liability in the balance sheet. The reason for this accrual is based on the matching principle as if sales revenue of $2,000,000 has been recorded, all associated expenses with this sales revenue need to be recorded and properly matched against sales revenue.

But now let’s move from understanding ...