Prepaid expenses: paid now, used later
If you pay an annual insurance premium in November, most of the benefit falls in the next year. Under accrual accounting, you hold the unused part as an asset called prepaid expense and release it to expense month by month. The same idea applies to annual software subscriptions, rent paid ahead and prepaid dues.
Keep the invoice, the payment record and a schedule that shows how the amount is spread over time.
Accrued expenses: used now, billed later
The opposite case happens when you have received a service or goods but not yet a bill. Examples are utilities for the last weeks of December, a contractor's work done in the year but invoiced in January and interest on a loan owed but not yet paid. An accrual records the cost in the right year and the amount owed as a liability.
Estimate carefully, using the last bill, the contract or the contractor's confirmation, and write down how you estimated.
Accrued payroll and vacation
If the last pay period straddles year end, wages earned but unpaid should be recorded as a liability along with the related employer taxes. Whether vacation or paid time off must also be accrued depends on your policy and your state, so ask your advisor. Keep the calculation sheet.
A payroll provider's reports usually give the information you need for pay periods that overlap the end of the year.
Reversing entries save headaches
A common bookkeeping approach is to record an accrual on December thirty-first and set it to reverse automatically on January first. When the real bill arrives, you record it in the normal way, and the reversal removes the duplicate. This keeps January accurate without special tracking.
Make sure the reversal is dated correctly. A forgotten reversal doubles the cost in the new year.
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Know your method and keep it consistent
A business on the cash method records items when money moves, and it generally does not accrue or defer in the same way for tax. Even so, some owners keep management reports on the accrual basis to see true monthly profit. Tell your bookkeeper which basis your reports should follow and tell your preparer how the return is prepared.
Changes between methods require advice. See our guide comparing cash and accrual accounting for the basics.
A simple prepaid schedule
Build a table with the item, vendor, payment date, amount, coverage start and end, monthly amount and remaining balance. Each month, move the monthly amount into expense. At year end, the remaining balances total the prepaid asset on the balance sheet, and you can see them all at a glance.
Review the schedule when contracts renew so the new period starts cleanly and the old one ends on the right date.
Worked example with numbers
On October 1 you pay $2,400 for a 12-month insurance policy. At December 31, three months (October, November, December) have been used. Expense for the year is $2,400 x 3/12 = $600, and the remaining $1,800 stays on the balance sheet as a prepaid asset.
Separately, a $310 December electric bill arrives January 9. At year end, record debit utilities $310 and credit accrued liabilities $310, so December carries its cost. When you pay the bill in January, debit accrued liabilities and credit cash, so expense is not counted twice.
Mistakes that cost money
Expensing the whole policy in the month paid and never recording the prepaid asset overstates expense in one year and understates it the next. Forgetting accruals for bills dated in January makes the old year look more profitable. Not amortizing prepaid balances monthly leaves a growing balance nobody can explain. Keeping a prepaid balance after the coverage has ended leaves an asset that no longer exists.
Check your work
List every prepaid and accrued balance with the start date, end date and monthly amount. Recompute each balance; the schedule should total the balance sheet line.
Common questions
Do I need to accrue every small bill?
Apply a reasonable threshold. Ignore tiny items, but make sure you capture the larger ones.
Does paying early reduce taxes?
It depends on your method and rules. Ask your preparer before changing payment timing for tax reasons.
This guide is general information, not tax, legal or accounting advice. Rules, fees and due dates change; check with the IRS, the NJ Division of Taxation or a licensed professional for your situation.