Let’s take a closer look at accrued expenses

At the end of the reporting period, most businesses have accumulated operating costs that won’t be paid until the next period. If your business prepares financial statements under U.S. Generally Accepted Accounting Principles (GAAP), certain unpaid costs may need to be reported as accrued expenses. Overlooking them can understate your business’s liabilities and overstate its profits. Accurate bookkeeping requires knowing which obligations to report on your financial statements and why recognizing an expense for accounting purposes doesn’t necessarily generate an immediate tax deduction.

Unpaid obligations

Businesses that issue GAAP financial statements use the accrual method of accounting. Accrual-basis accounting generally requires recognizing expenses when incurred, regardless of when you pay them. At the end of the accounting period, your business may have incurred expenses in the current period that it hasn’t yet paid or recorded in its financial statements. Unrecorded expenses incurred in the current period require adjusting entries.

For instance, if your business has borrowed money to finance operations or capital assets, it’s accumulating interest costs daily. An adjusting entry may be needed at the end of the accounting period to record the interest accumulated during that period. Interest payable generally appears on the balance sheet as a current liability if due within one year or the operating cycle, whichever is longer. The related cost generally appears on the income statement as interest expense, though interest incurred during the construction or production of qualifying assets may need to be capitalized.

Other common examples of expenses that may be owed but unpaid at the end of the period include taxes, utilities, professional fees, and employee wages, bonuses and benefits. By accruing expenses, a business matches revenue earned in the accounting period with the related expenses incurred in that period. Reporting many accrued expenses, such as accrued interest, is straightforward. However, reporting certain accrued expenses may be more complicated because it requires estimates.

Significant accruals

GAAP doesn’t require a separate footnote describing every accrued expense or every estimation method. Presentation and disclosure depend on materiality and the accounting guidance applicable to the underlying obligation. Significant accrued liabilities may warrant separate presentation on the balance sheet or additional detail in the footnotes.

For example, a business might provide the following disclosure for accrued wages and benefits:

As of December 31, 2026, the business has accrued $300,000 for wages and related benefits, representing employee compensation earned but unpaid as of the balance sheet date. The accrual includes salaries, bonuses and payroll taxes. These amounts are expected to be paid in the first quarter of the following fiscal year. Management regularly reviews and adjusts the accruals based on actual compensation and obligations.

Businesses must also disclose their use of estimates in preparing financial statements. Additional disclosure may be required when a significant estimate is subject to uncertainty and could change materially in the near term. Other guidance may require disclosures about particular obligations or material changes in estimates.

Book-tax differences

Some businesses apply different rules for recognizing income and expenses for tax purposes. Specifically, certain small businesses can choose to use cash-basis accounting for federal income tax purposes. For tax years beginning in 2026, the inflation-adjusted gross receipts threshold is $32 million in average annual gross receipts over the previous three tax years. Eligibility may be subject to additional rules and restrictions.

If your business chooses to use cash-basis accounting for tax purposes, some expenses recorded on your GAAP financial statements may not be deductible in the same tax year. Under the cash method, you generally report income when you actually or constructively receive it and deduct expenses when you pay them, rather than when you incur them (as under the accrual method). Using cash-basis accounting for tax purposes may defer taxable income, but it can also delay deductions for unpaid expenses. Exceptions apply, including rules requiring certain costs to be capitalized.

Special rules for accrued bonuses

Special tax rules apply to accrued employee bonuses. Cash‑basis employers generally must deduct bonuses in the year they’re actually paid, regardless of when they’re earned. However, accrual-basis employers can generally deduct accrued bonuses in the year employees earn them if the applicable requirements are satisfied, including:

• Bonus amounts are fixed obligations by the end of the tax year,
• Bonus amounts are reasonably determinable, and
• Bonuses are paid within 2½ months after the end of the tax year (generally March 15 for calendar-year businesses).

If the business delays bonus payment beyond this period, the deduction is generally deferred until the year the employee includes the payment in income, typically the payment year, under the deferred compensation rules.

Bonus plan terms also matter. For example, requiring employees to remain employed through the payment date may prevent a year-end deduction if forfeited bonuses revert to the employer. One possible workaround is to establish a bonus pool. If the other requirements are met, employers may deduct bonuses in the year they’re earned, as long as they reallocate any forfeited bonuses among the remaining employees in the pool. Under such a plan, the aggregate bonus amount is fixed at year end, even though amounts allocated to specific employees may not be determined until the payment date.

In addition, the favorable tax treatment for deducting accrued bonuses may be limited by the related-party rules. Under these rules, bonuses owed to cash-basis related parties generally aren’t deductible until the recipients include them in income, typically when paid. In general, this applies to shareholders who directly or indirectly own more than 50% of the value of a C corporation’s outstanding stock and to S corporation shareholders regardless of ownership percentage. These rules can be complicated, especially for partnerships and limited liability companies, so contact your tax advisor to discuss the appropriate treatment for your situation.

Errors and manipulation

Reporting accrued expenses can be challenging and requires meticulous recordkeeping, especially when a business follows different rules for recognizing expenses for book and tax purposes. Errors and omissions may happen when making estimates or matching expenses to the proper accounting period, resulting in under- or overstated liabilities. Some businesses may also misclassify accrued expenses, causing confusion in financial reporting.

In addition, accrued expenses can be vulnerable to fraud schemes. For instance, fake accruals for nonexistent expenses may be used to create a reserve that can be reversed to inflate future profits. Or management might hide bills or manipulate estimates to avoid recognizing accrued expenses in the current period, artificially inflating profits. External audits can help detect these schemes, but they provide reasonable, rather than absolute, assurance that financial statements are free of material misstatement due to fraud or error. Your accountant can also recommend antifraud controls to fortify your defenses.

Strengthen your review

A consistent closing process helps ensure your financial statements accurately reflect unpaid obligations. Giving accrued expenses the attention they need provides owners, lenders and investors with a clearer picture of profitability and financial health. Contact us for help reporting your business’s accrued expenses and related disclosures.

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