The concepts of prepaid and accrued expenses can sometimes be confusing and, unless you deal with them all of the time, it can be easy to forget how to account for them properly.
First off, prepaid and accrued expenses generally are taken into account when your accounting records are prepared on the accrual basis. When you are keeping your books on the cash basis of accounting, you are deducting expenses when you pay them; therefore, from purely an accounting point of view, you won’t have any expenses that you paid ahead of time or any expenses that you will owe someone for (even if you do still do owe someone for them). You can read more about the cash versus accrual basis of accounting here.
One concept to remember is that under the accrual method of accounting, expenses must be “matched” to the income they are used to produce or the period of time when they are used. Keep that in mind as we go further in our explanation.
What is a prepaid expense?
As the name suggests, a prepaid expense is one that the payment for the expense is made before the period of time or the income it is used to generate occurs.
For instance, if ABC Company has an insurance policy that costs $12,000 per year, the insurance expense would be $1,000 per month. If ABC were to pay the premium in full on January 1, ABC would have prepaid insurance for the unexpired portion of the insurance throughout the year.
Let’s look at how the numbers work in the ABC example:
Total insurance for the year (paid on January 1) $12,000
Monthly amount of insurance expense $1,000 ($12,000 divided by 12 months)
At the end of January, $1,000 of the insurance that was paid for would be expensed leaving $11,000 as prepaid.
At the end of February, another $1,000 of the insurance that was paid for would be expensed leaving $10,000 as prepaid.
What is an accrued expense?
Following the same logic discussed above, an accrued expense is one where the expense has been incurred but not yet paid.
For instance, it ABC company has an insurance policy that costs $12,000 per year, the insurance expense would again be $1,000 per month. However, if ABC were to pay the premium in full on the last day of the year (December 31), ABC would still have to record insurance expense for the expired (or used) portion of the insurance policy throughout the year.
Let’s look at how the numbers for the accrual work in the ABC example:
Total insurance for the year (paid on December 31) $12,000
Monthly amount of insurance expense $1,000 ($12,000 divided by 12 months)
At the end of January, $1,000 of the insurance that was not yet paid for would need to be expensed by recording (or accruing) it on ABC’s books, which would show $1,000 of accrued insurance on the balance sheet and $1,000 of insurance expense for the month.
At the end of February, another $1,000 of the insurance that was not yet paid for would need to be expensed by recording (or accruing) it on ABC’s books, which would now show $2,000 of accrued insurance on the balance sheet at the end of February and another $1,000 of insurance expense for the month.
The concept of prepaid and accrued expenses may not seem that difficult; however, it is important to properly track your expenses and calculate any prepaids or accruals at the end of your company’s reporting period.
