Some bills do not line up with the months they cover. You pay a year of insurance in January. Your crew works the last week of the month but gets paid on the 5th. December's electricity bill shows up in January. If the books record each of these only on the day cash moves, one month looks terrible and the next looks great, and neither number tells you how the business actually did.
Prepaid and accrued expenses are the two adjustments that fix this. They are mirror images of each other: one is paying before you use something, the other is using something before you pay for it.
Prepaid expenses: paid now, used later
A prepaid expense is a payment for something you will use up over future months. Because the benefit has not been used yet, it is recorded as an asset — usually an account called prepaid expenses — not as an expense. Each month, the portion you used moves from the asset to the expense account.
Example: on January 1 you pay $6,000 for a 12-month general liability policy. The entry is a $6,000 increase to prepaid insurance and a $6,000 decrease to cash. At the end of each month, $500 moves from prepaid insurance to insurance expense. By December 31 the asset is down to zero and the full $6,000 has been expensed, $500 at a time, in the months the coverage actually applied.
Common prepaids: annual insurance premiums, annual software subscriptions, rent paid in advance, and retainers paid ahead of services. Small, routine items — a $15 monthly subscription — are not worth spreading out. Most businesses set a dollar threshold and expense anything under it immediately.
Accrued expenses: used now, paid later
An accrued expense is a cost you have already incurred but have not paid, and often have not been billed for yet. It is recorded as an expense in the month it happened, with a matching liability — usually accrued expenses or accrued wages — until the bill is paid.
Example: your crew earns $8,400 in wages during the last week of March, but payday is April 5. At March 31 you record $8,400 of wages expense and an $8,400 accrued wages liability. When payroll runs on April 5, the payment clears the liability instead of hitting April's expenses a second time. March's profit now reflects March's labor.
Common accruals: wages earned but not yet paid, utilities used but not yet billed, interest that has built up on a loan since the last payment, and professional fees for work already performed. Many bookkeepers record accruals as reversing entries — the entry is reversed on the first day of the next month, so the real bill can be recorded normally when it arrives without being counted twice.
Does a small business need to bother?
If you keep your books on a pure cash basis, you record expenses when paid and skip both adjustments. That is simpler, and many small businesses file their taxes that way. The cost is that monthly results swing with payment timing, which makes it hard to compare months, price jobs, or show a lender a clean trend.
Accrual-basis books — or cash-basis books with a few adjustments for large items like annual insurance and month-end payroll — give a far more honest monthly picture. Your books and your tax return also do not have to treat every item identically: for example, cash-basis taxpayers can generally deduct certain prepaid expenses in the year paid if the benefit does not extend beyond the earlier of 12 months after it begins or the end of the following tax year. How your return handles these items is a decision for your tax preparer; how your monthly reports handle them is about seeing the business clearly.
The most common problem is not choosing the wrong method but mixing them by accident: an annual premium expensed in one month, a mid-year policy change booked somewhere else, and a balance in prepaid expenses that nobody can explain. Whatever approach you use, the prepaid and accrued balances on your balance sheet should tie to a simple schedule showing exactly what is in them.
Get the timing right every month
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If your balance sheet has prepaid or accrued balances nobody can explain, cleanup is $199 for each month behind, completed within 2 days and guaranteed in writing. No contracts, cancel anytime. Get an instant quote on our homepage.