Accrued Expenses vs Accounts Payable – Interview Question (12:43)
Accounts Payable vs. Accrued Expenses on the 3 Financial Statements: Why Does It Matter?
It’s a common interview question! You may be asked about the differences between them, how changes are reflected on the 3 financial statements, and so on.
And most Google search results on this topic are AWFUL and do not answer the actual question at all, or do so in a confusing way that misses the point (trust me, I looked).
THE SHORT ANSWER: Accounts Payable (AP) and Accrued Expenses (AE) work in a VERY similar way… IF they both correspond to Operating Expense line items, or other items that appear directly on the Income Statement.
However, AP is more likely to correspond to events such as the purchase of Inventory, which would NOT show up on the Income Statement initially, and so you’re more likely to see different treatment with Accounts Payable (no Income Statement impact – just an Asset on the Balance Sheet increasing and AP on the Liabilities & Equity side increasing to balance the change).
Both these items represent cases where we’ve INCURRED an expense but not actually paid for it in cash yet.
Example 1: We get an invoice for a legal bill from a law firm we hired. They already performed the service, so we incurred the expense, but we haven’t paid them in cash yet.
Example 2: We pay rent at the beginning of each month. In between, that expense accrues because we use the building or office every day of the month… so it’s not accurate just to view it as an expense on one day of the month, but rather an expense that gets accrued every single day and then paid in cash at the beginning of the month.
Example 1 corresponds to Accounts Payable, because we typically use AP for items with specific invoices.
Example 2 corresponds to Accrued Expenses, which we typically use for recurring, monthly/quarterly/weekly items WITHOUT specific invoices, such as rent, utilities, employees’ wages, and so on.
What Happens on the 3 Statements When AP or AE Change?
IF they both correspond to COGS or Operating Expenses IN THE CURRENT PERIOD and therefore refer to actual expenses listed on the Income Statement:
Let’s use the example of AP or AE of $100 on the 3 statements:
1) Income Statement – Expenses (most likely OpEx) will increase by $100, reducing Pre-Tax Income by $100 and Net Income by $60 assuming a 40% tax rate.
2) Cash Flow Statement – Net Income is down by $60, but this expense we just recognized was non-cash, so we record the increase in AP or AE as a cash increase of $100.
Our cash flow and ending cash at the bottom are up by $40.
3) Balance Sheet – Cash is up by $40 on the Assets side; on the L&E side, AP or AE is up by $100, but Retained Earnings is down by $60 due to the reduced Net Income, so both sides are up by $40.
INTUITION: You’ve saved on taxes because you recorded an expense, took the tax deduction, and reduced your tax bill… but you haven’t paid that expense in cash yet! It’s all about the tax savings in this first step.
Now, Step 2: What Happens When You Pay the AP or AE in Cash, For Real
1) No changes on the Income Statement – already recognized this as an expense!
2) Cash Flow Statement: Net Income is still down by $60… and now we REMOVE that adjusting entry for AP or AE, so cash no longer goes up by $100 from that.
As a result, cash at the bottom is just down by $60.
3) Balance Sheet: Cash is now down by $60 rather than being up by $40, because we just paid that expense in cash.
On the other side, AP or AE is now back to its old level and is no longer up by $100. Retained Earnings is still down by $60, so both sides are down by $60 and balance.
BUT HERE’S THE IMPORTANT DIFFERENCE BETWEEN THEM:
AE almost always correspond to Operating Expenses or other Income Statement expense items… but Accounts Payable often do not.
EXAMPLE: Company buys $100 of Inventory on credit – supplier sends over the Inventory, “in good faith,” and sends the company an invoice, which goes to its Accounts Payable account.
In this case, there are NO CHANGES on the Income Statement because nothing happens there until this Inventory is turned into products and sold to customers!
Instead, Inventory on the BS simply goes up by $100, and AP on the other side goes up by $100 to balance it.
That scenario happens a lot with AP, but very-rarely-to-never with AE.