Meet Sam. In January, Sam pays $240 for a twelve-month coffee bean subscription. A bag shows up on the doorstep every month. Sam feels very organized.
Sam also has a tab at the cafe downstairs, where the barista writes down every latte and sends a bill at the end of the following month. January's tab comes to $65, billed in February.
So, how much did Sam spend on coffee in January? Not $240 (that's a year of beans). Not $0 from the cafe, either (those lattes were very much consumed in January). The plain answer is $20 of beans plus $65 of lattes: $85.
Congratulations. You now understand accrued expenses vs prepaid expenses. The rest of this article is the business version, with fewer lattes.
Accrual accounting explained in two sentences
Accrual accounting records income when you earn it and expenses when you use them, regardless of when cash moves. Cash accounting records them when money actually comes in or goes out.
Both are legitimate, and which one fits your business is a bigger question we cover in accrual vs cash accounting. Accruals and prepaids are the two adjustments that make accrual accounting work, because cash and usage rarely happen in the same month.
What are prepaid expenses?
Prepaid expenses are costs you pay before you use them. Sam's $240 of beans is the coffee version. Business examples:
- An annual insurance policy paid upfront
- A year of software billed in one payment
- Rent paid a few months in advance
When you pay, the money goes to a balance sheet asset account called Prepaid Expenses, because you've bought something you haven't used yet. Each month, the used portion moves to the P&L.
Say your business pays $7,200 for a year of liability insurance on January 1. In January:
- Record the payment: Prepaid Insurance goes up $7,200, cash goes down $7,200.
- At each month end, move $600 from Prepaid Insurance to Insurance Expense.
- By December 31, Prepaid Insurance is zero and the full $7,200 has hit the P&L, $600 at a time.
Without this, January looks like a disaster and the other eleven months look suspiciously cheap.
What are accrued expenses?
Accrued expenses are the cafe tab: costs you've already incurred but haven't been billed for or paid. Common examples:
- Utilities used in March, billed in April
- Contractor hours worked in the last week of the month, invoiced next month
- Wages employees earned through month end but will be paid in the next payroll
- Interest that's built up on a loan since the last payment
At month end, you record an expense on the P&L and a matching liability (often called Accrued Liabilities) on the balance sheet. When the bill arrives and gets paid, it clears the liability instead of hitting expenses a second time.
Accrued expenses vs prepaid expenses in a design studio's March
Let's say you run a five-person design studio with $48,000 of March revenue. Without any adjustments, your March books show:
- An annual software renewal of $3,000, paid in March, all expensed
- No freelancer cost, because two freelancers who worked in March won't invoice until April for $4,500 total
- Net income of $9,800
Now adjust. The software is a prepaid: only $250 belongs in March, so $2,750 moves to Prepaid Expenses. The freelancers are an accrual: $4,500 of March work gets recorded as an expense with an accrued liability.
New net income: $9,800, plus $2,750, minus $4,500, equals $8,050. Lower, yes, but true. And April won't look mysteriously worse when the freelancer invoices land, because March already carried them.
Where these entries fit in the month-end close
Accruals and prepaids are adjusting entries, posted after transactions are entered and bank accounts reconciled, but before the balance sheet review. Our article on the month-end close process: who does what, and in what order shows exactly where they land.
They also need a schedule. A one-page list of every prepaid (what was paid, how many months, what's left) and every accrual (what it's for, when it'll be billed) is what lets a reviewer check the balance. A controller should look at both each month; that review is part of our controller services.
If you sell retainers or get paid upfront for services, you have the mirror image on the revenue side: deferred revenue, which is money received before it's earned. We cover that in accounting for consultants: retainers, deferred revenue, and paying yourself.
Questions owners ask
Is a prepaid expense an asset or a liability?
A prepaid expense is an asset. You've paid for something you'll use in future months, so it sits on the balance sheet and moves to expense as you use it.
Is an accrued expense a liability?
Yes. An accrued expense is a cost you've incurred but haven't paid yet, so it's recorded as a liability until the bill is paid.
Do small businesses need to record accruals and prepaids?
If you keep your books on the accrual basis, yes, at least for amounts large enough to change the picture. Many businesses set a dollar threshold so tiny bills don't hold up the close.
More plain-English accounting, minus the lattes
If the coffee version helped, you'll probably enjoy The ABFI Accounting Brief: practical notes on books, closes, reporting and CPA handoffs, with no market-news filler. Subscribe to The ABFI Accounting Brief for the next explainer. And if your prepaid and accrual schedules are more "intentions" than "schedules," you can request a consultation and we'll help set them up.