Written by Behdad Karimi Dermeni, CPA · Reviewed by Maryam Ajorloo, CPA
Accrued expenses are costs you have already incurred but have not paid yet, so they sit on your balance sheet as a liability. Prepaid expenses are the reverse: costs you have paid in advance for something you have not used yet, so they sit on your balance sheet as an asset. The difference comes down to which came first, the cash or the benefit.
You probably met these two terms on a balance sheet, in a note from your accountant, or in a loan application that asked for "accrual-basis financials" like it was no big deal. They sound like jargon invented to keep accountants employed. They are actually two halves of one simple idea, and once you see it, you will spot both in your own business within about 30 seconds.
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The one rule that settles it
Here is the rule of thumb: an expense belongs to the period when you get the benefit, not the period when the money moves. When the benefit arrives before the bill, you have an accrued expense. When the money leaves before the benefit, you have a prepaid expense.
That is the whole trick. Everything below is that rule applied to real situations, plus the part your tax return cares about (which, fair warning, has its own opinions).
What are accrued expenses?
An accrued expense is a cost you have already racked up but have not paid by the end of the period. You owe it, you just have not been asked for the money yet. Because it is money you owe, an accrued expense is recorded as a liability, usually called "accrued expenses" or "accrued liabilities."
Common accrued expenses examples for a small business:
Wages earned but not yet paid. Your team works the last week of December, and payday lands on January 6.
Utilities. You used the electricity and internet in December, and the bill shows up mid-January.
Contractor work. A freelancer finishes a project for you on December 20 and invoices you in January.
Interest on a loan. Interest builds up daily, but the lender only collects it once a month or once a quarter.
Professional fees. Your accountant prepares your year-end package in December and bills in February. (December invoices have a way of turning into February invoices.)
In each case, the cost helped you earn December's revenue, so it belongs to December, even though the cash leaves in January.
What are prepaid expenses?
A prepaid expense is a cost you pay up front for something you will use over time. Until you use it, you have not really "spent" it, you have bought a future benefit. That makes a prepaid expense an asset on your balance sheet, usually listed under current assets.
Common prepaid expenses examples:
Prepaid insurance. You pay 12 months of business insurance on day one.
Annual software subscriptions. The yearly plan is cheaper, so you pay it all at once. (The monthly plan is always mysteriously more expensive. Funny how that works.)
Prepaid rent. Your landlord asks for the first and last month's rent at signing, or you pay a quarter in advance.
Retainers you pay out. You pay a lawyer or consultant a retainer that they draw down as they work.
Conference tickets and trade show booths booked months ahead.
As each month of coverage or service passes, a slice of the prepaid asset gets "used up" and moves onto your income statement as an expense.
Accrued vs prepaid expenses side by side
If you only skim one section, make it this one:
Timing: Accrued means the benefit comes first and you pay later. Prepaid means you pay first and get the benefit later.
Balance sheet: Accrued expenses are a liability (money you owe). Prepaid expenses are an asset (value you have not used yet).
What happens next: An accrued expense disappears when you pay the bill. A prepaid expense shrinks month by month as you use it up.
Typical examples: Accrued covers wages, utilities, interest, and contractor work. Prepaid covers insurance, rent, software plans, and retainers.
Effect if you ignore it: Skip accruals and the period looks more profitable than it was. Skip prepaids and the period looks less profitable than it was.
That last point is why lenders and investors care. Neither one changes how much cash you have, but both change the profit story your financial statements tell.
Accrued expenses vs accounts payable
These two are cousins, and people mix them up all the time. Both are liabilities, and both are money you owe. The difference is the paperwork.
Accounts payable is a bill you have actually received. The vendor sent an invoice, you know the exact amount, and it is waiting to be paid.
Accrued expenses are costs you owe but have not been billed for yet, so the amount is often an estimate (December's electricity, wages for the last few days of the year).
Once the invoice arrives, the accrued expense effectively turns into a regular bill, and then you pay it. Same debt, different stage of life.
How to record accrued and prepaid expenses
You do not need to be an accountant to follow the entries. Both are recorded with an adjusting entry at the end of a month or year, and both follow the same 5 steps.
List what you owe but have not been billed for. Go through wages, utilities, contractor work, and interest that belong to the period but have not been paid.
List what you paid in advance. Pull up insurance, rent, annual subscriptions, and retainers that cover future months.
Estimate each accrued amount. Use last month's bill, the contract rate, or the hours worked. A reasonable estimate beats a blank.
Work out the unused portion of each prepaid. Divide the total by the months it covers and count how many months are left.
Record the entries and reverse or reduce them next period. Accrued expenses come off when the bill is paid; prepaid balances shrink each month as you use them.
Here is what that looks like with numbers.
Accrued expenses journal entry. Your December internet and electricity come to $400, billed January 15.
December 31: debit Utilities expense $400, credit Accrued expenses $400.
January 15, when you pay: debit Accrued expenses $400, credit Cash $400.
December carries the cost it actually used, and January is not stuck with last year's bill.
Prepaid expenses journal entry. On October 1, you pay $1,200 for a 12-month software plan.
October 1: debit Prepaid expenses $1,200, credit Cash $1,200.
End of each month: debit Software expense $100, credit Prepaid expenses $100.
By December 31, $300 has been expensed and $900 is still sitting on your balance sheet as an asset. The $900 is not lost money. It is 9 months of software you already own.
When can you write them off? The IRS side
Here is where things get interesting, because your books and your tax return can follow different rules. Which rules apply depends on whether you file taxes on the cash method or the accrual method (our guide to cash vs accrual accounting explains how to tell).
On the cash method (most small businesses), you generally write off an expense when you pay it. So accrued expenses do not count until the check clears: that December utility bill is a write-off in the year you actually pay it.
Prepaid expenses get a special rule. According to IRS Publication 538, an expense you pay in advance is deductible only in the year it applies to, unless it qualifies for the 12-month rule. Under that rule, you can write off the full prepayment right away if the benefit does not extend beyond the earlier of:
12 months after the benefit begins, or
the end of the tax year after the year you paid.
Back to the $1,200 software plan from October 1: it runs exactly 12 months, so it qualifies, and a cash-method business can write off all $1,200 in the year it paid, even though the books only expensed $300. A 3-year insurance policy paid up front does not qualify, so that one gets spread over the years it covers.
On the accrual method, the IRS lets you deduct an expense once the liability is fixed, the amount can be determined with reasonable accuracy, and "economic performance" has happened (generally, the service or property has been provided to you). There are extra wrinkles, such as amounts owed to related people, which are generally not deductible until paid. This is a good moment to let your accountant earn their fee.
The short version: the tax rules can be kinder than the bookkeeping rules on prepaid expenses, and stricter on accrued ones. (Tax law, consistent as ever.)
Do you even need to track these?
If you run a small service business on the cash method, you may never book a formal accrual during the year, and that is completely normal. Your bank activity is your bookkeeping, and your profit and loss statement reflects what actually moved.
Accruals and prepaids start to matter when:
A lender, investor, or buyer asks for accrual-basis statements. They want the profit you earned, not just the cash that happened to move that month.
You make big lumpy payments. A $12,000 annual insurance bill paid in January makes January look like a disaster and the other 11 months look suspiciously great.
You are planning a budget. Spreading prepaids across the months they cover gives you a truer monthly cost of running the business, which is exactly the number to plug into our free Business Budget Calculator.
One thing we hear often from business owners: "My accountant changed my profit at year-end and I don't know why." Nine times out of ten, the answer is a handful of adjusting entries like the ones above. Nothing went wrong. Your accountant moved costs into the period where they belong.
3 tips for handling accrued and prepaid expenses
Keep the paperwork for anything paid in advance. Your insurance policy, software receipt, or lease shows the coverage dates, which is exactly what you (and the 12-month rule) need to split the cost correctly.
Make a short year-end list. Two columns: "used but not billed" and "paid but not used." Ten minutes in December saves your accountant an hour of emails in March.
Keep the cash side spotless all year. Accruals are a layer on top of clean, categorized transactions. If every payment is already categorized and matched to its receipt, the year-end adjustments take minutes instead of a weekend.
How ReInvestWealth fits
ReInvestWealth keeps your books on what actually moved through your accounts, which is the cash-basis view most service businesses file on. Connect your bank and cards, and the AI Bookkeeper categorizes every transaction as it comes in. Forward or upload receipts to Smart Shoebox (your receipt inbox), and they get matched to the payments they belong to, so the policy or annual plan behind a big prepayment is one click away.
When your accountant needs to layer accruals or prepaids on top at year-end, invite them into your account. They start from clean, receipt-backed books, so you pay for their judgment instead of their data entry. 3,000+ entrepreneurs run their books on ReInvestWealth, which means this is a well-worn path rather than an experiment. Built by CPAs, so you don't have to be one.
Frequently asked questions
Is a prepaid expense an asset?
Yes. A prepaid expense is a current asset because you have paid for a benefit you have not used yet, such as insurance coverage or a software plan. As each month passes, the used portion moves from the balance sheet to the income statement as an expense.
Are accrued expenses a liability?
Yes. Accrued expenses are a current liability because they are costs you have incurred but not yet paid, like wages earned at year-end or a utility bill that has not arrived. The liability goes away when you pay the bill.
Is prepaid insurance deductible in the year I pay it?
On the cash method, often yes. Under the IRS 12-month rule, you can deduct a prepayment in full in the year you pay it if the coverage does not extend beyond 12 months after it begins or the end of the following tax year. A multi-year policy is spread over the years it covers.
What is the difference between accrued and deferred expenses?
They are opposites. An accrued expense is recorded before you pay it, because you have already received the benefit. A deferred expense (another name for a prepaid expense) is paid before you record it as an expense, because the benefit comes later.
Is unpaid payroll an accrued expense?
Yes. Wages your team has earned but you have not paid by the end of the period are a classic accrued expense, along with the employer payroll taxes on those wages. They are recorded as a liability until payday.
Clean cash books first, adjustments second
Accrued and prepaid expenses are just timing, and timing is easy to fix when the underlying transactions are already in order. Connect your bank, let the AI Bookkeeper categorize everything, and hand your accountant books they will actually enjoy opening. CPA-level clean books, 30 days free. Start for free
A note from our CPAs: This guide is educational and covers the general rules for US small businesses. Tax situations vary, so for advice on your specific circumstances, talk to your accountant. (If they use ReInvestWealth, they'll already have clean books to work from.)
Written by Behdad Karimi Dermeni, CPA
Co-founder of ReInvestWealth and a founding community builder at Stripe. Behdad built ReInvestWealth to give smart, busy entrepreneurs CPA-level accounting without the CPA-level price tag. Read more · Connect on LinkedIn
Reviewed by Maryam Ajorloo, CPA
Maryam Ajorloo is a CPA who specializes in small business tax, sales tax, and everyday bookkeeping. She helps entrepreneurs keep clean, audit-ready books and make sense of write-offs, filing deadlines, and the numbers behind their business. Read more · Connect on LinkedIn
