Accrued and prepaid expenses are two of the most common adjustments in any real set of books, and two of the most commonly mixed up. They exist for the same reason: to put an expense in the period it actually belongs, instead of the period the cash happened to move. If your books skip them, your monthly profit bounces around for no real reason and none of the months are quite right.
They are mirror images of each other, so the easiest way to keep them straight is to think about timing: did you pay before or after you used the thing?
Prepaid expenses: pay now, use later
A prepaid expense is cash you have paid for something you have not used yet. Because you have not consumed the benefit, it is not an expense yet. It is an asset, a thing of value you are owed.
The classic example is annual insurance. You pay 12,000 dollars in January for a full year of coverage. If you expensed the whole amount in January, that month would look terrible and the other eleven would look artificially good. Instead you record the 12,000 as a prepaid asset, then move 1,000 to expense each month as the coverage is used up. By December the asset is zero and each month carried its fair share. The same logic applies to annual software subscriptions, retainers paid up front, and prepaid rent.
The entries: when you pay, you debit prepaid expense (asset) and credit cash. Each month, you debit expense and credit prepaid expense to draw the asset down.
Accrued expenses: use now, pay later
An accrued expense is the opposite. You have used something but have not paid for it yet, and often have not even received the invoice. The expense still belongs in the period you used it, so you record it now and recognize that you owe the money.
A common example is a contractor who does work in March but does not invoice until April. If you wait for the invoice, March understates its true cost and April overstates it. Instead, at the end of March you accrue the estimated cost: it hits March as an expense and sits as a liability (accrued expenses payable) until you pay it. Payroll earned but not yet paid, utilities used but not yet billed, and interest that has built up all work the same way.
The entries: at period end you debit expense and credit accrued liabilities. When the bill arrives and you pay, you clear the liability against cash.
Why this matters
Both entries do the same job: they match expenses to the period that actually benefited from them. That is the heart of accrual accounting and the reason accrual books are worth more than cash-basis books. Without these adjustments, a quarter's worth of insurance or a big unbilled contractor cost lands in one random month, and your gross margin and net income for every affected month are wrong. You end up making pricing and hiring decisions on noise.
Get them right and your monthly P&L becomes comparable and trustworthy. A jump in expenses means something real happened, not that an annual bill happened to hit that month.
- Prepaid = paid before used. Sits as an asset, expensed over time. Think annual insurance or software.
- Accrued = used before paid. Sits as a liability, expensed now. Think unbilled contractor work or earned payroll.
- Both exist to put the expense in the right month, which is what makes accrual books reliable.
These adjustments are part of a proper monthly close, and running them correctly every month is core to how our accounting team keeps your books decision-ready.