What are Accrued Wages?
Accrued Wages represent the unmet employee compensation remaining at the end of a reporting period, i.e. the balance of unfulfilled payroll expenses. The expense is recognized on the income statement because the employees have “earned” the payment, but the cash payment remains unmet.
Accrued Wages Definition in Accounting
The accounting term “accrued wages” describes the unpaid compensation not yet paid by a company to employees for the services they have already provided.
Accrued wages are categorized under the accrued expenses line item, which is a current liability on the balance sheet.
An accrued wage is incurred and recognized on the income statement per the matching principle—in spite of the fact that the employees have not actually been paid—to abide by the reporting guidelines established per accrual accounting standards.
While the cash outflow from the payment to the employees has not yet occurred, the expense must be recognized in the period in which the employees provided the services.
The matching principle is intended to “match” the recognition of costs with the timing of the corresponding revenue (i.e. the monetary benefits).
Accrued Wages Journal Entry: Debit and Credit Entry
The initial journal entry of an accrued wage is a “debit” to the employee payroll account, with the coinciding adjustment being a “credit” entry to the accrued wages account.
- Employee Payroll Account → Debit
- Accrued Wages → Credit
For example, suppose the accrued wages at the end of a month is $20,000.
The initial journal entry on the company’s books is as follows.
The entry reverses at the beginning of the following reporting period, assuming the company follows through with the payment on time.
Accrued Wages Example: Employee Payroll Accounting
For instance, suppose a company pays its employees on a bi-weekly basis and the date on which the two-week period starts is near the end of the month of December (and crosses over into the next month, January).
The monetary benefit related to the productivity of the employees was already received—i.e. the employees have delivered their services to the company as part of their employment agreement—so, the expense must be recognized in the month of December.
However, the employees are not expected to receive their owed compensation in the form of cash until the following month, which would be early January in our scenario.
When the accounting department of the company closes their books at the end of December, the accrued wage balance increases from the unmet employee wages resulting from the temporary mismatch in timing.
How Accrued Wages Impact Free Cash Flow (FCF)
The cash flow impact of the recognition of accrued wages is similar to that of accounts payable, where the cash remains in the possession of the company until issuance to the employees.
Since the cash was not paid yet, the impact on a company’s free cash flow is positive, as the company can use those proceeds for other activities in the meantime until the date of cash payment.
- Increase in Accrued Wages → Increase in Free Cash Flows (”Source of Cash”)
- Decrease in Accrued Wages → Reduction in Free Cash Flows (”Use of Cash”)
The intuition is that an increase in accrued wage leads to more short-term liquidity because the owed cash payment to employees is retained by the company.
On the other hand, a decline in the accrued wages balance occurs when the company fulfills the payment obligation to their employees (and results in less cash on hand).
Accrued Wages and Employee Churn Rate
There is a “cap” in terms of the duration in which a compensation-related payment can be delayed, unlike delayed payments to suppliers or vendors.
For instance, if a company continuously delays their payments to employees for the sake of benefiting from increased near-term liquidity, it is inevitable for employee complaints to start rolling in (and it is overall a bad business practice).
While a company can intentionally extend their payables to suppliers, delaying payment of an accrued expense like accrued wages is more unintentional and stems from mismatches in timing.
In the long term, it is best for companies to take care of accrued wages as quickly as possible, especially for purposes of employee retention and minimizing the employee churn rate.
Certain accrued expenses are due to a bill having not been processed, and the company is still awaiting the invoice, e.g. when a utility company has not yet sent the company the bill.
But for accrued employee wages, there is a contractual obligation by the company to pay the employees for the services received on time.