Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Accrued Liability

What it is:

Accrued liabilities are records of revenue and expenses in the periods in which they are incurred. They are a key component of the accrual method of accounting.

How it works (Example):

For example, let's assume Company XYZ must insure one of its buildings. The insurance company bills Company XYZ $600 every six months (one bill in January, the next in July). If each bill is for the last six months of coverage ($100 for each month times six months), then under the accrual method, Company XYZ essentially starts setting money aside for the months for which it has received insurance coverage but hasn't yet paid.

These "set asides" are accrued liabilities, and they appear on the balance sheet.

So, let's say that it's January. Company XYZ paid its bill for the last six months of coverage and won't get another bill from the insurance company until July. Thus, in January it records an accrued liability for $100 worth of insurance. In February, it adds another $100 to that accrual. In March, it adds another $100. In April, May and June, it adds $100 for each month to the accrued liability, too.

In July, the bill finally comes. At that point, Company XYZ has an accrued liability for $600 -- the amount of the insurance bill for the last six months of coverage. When it pays the bill, it reduces the liability to zero. The process starts again for the next six months.

Why it Matters:

Although it is more complex, harder to implement, and harder to maintain than the cash method of accounting, most analysts agree that accruals (and thus, accrued liabilities) provide a more accurate picture of a company's performance. That's because in any given accounting period, revenues are associated with their corresponding expenses, which gives a truer picture of the real costs of producing the revenue in a given period.

Additionally, accruals allow companies to reflect the fact that sales may have been made and expenses incurred even if cash has not changed hands yet (as is often the case with sales made on credit and similar circumstances). This in turn produces financial statements that are comparable over time.

However, one of the big drawbacks of accrued liabilities is that they tend to obscure the nature of the company's actual cash position (e.g., a company may show millions in sales but only have $10 in its cash account because its customers haven't paid yet).

Accrual accounting is the opposite of cash accounting, which recognizes economic events only when cash is exchanged. The accrual method is more common than the cash method, and the IRS often requires companies to use accruals when they have more than a certain level of revenues or carry inventory.