Issue #31

Prepaid and Accrued Expenses Land in the Wrong Month

Hollis Barnett opened her climbing gym in Chattanooga on a Tuesday in January, and by the last week of the month she had more memberships sold than her business plan projected for March. Foot traffic was steady. The chalk bill was the only thing rising faster than sign-ups.

Then her bookkeeper sent over the January income statement, and the gym showed a loss of about $11,000.

The culprit sat on one line. Hollis had written a check for $18,600 in general liability and equipment coverage, twelve months of premium paid up front because the carrier gave a discount for annual payment. The whole amount hit January.

She used one month of that insurance. She expensed twelve.

That single check is the cleanest illustration of what prepaid and accrued expenses exist to fix. Both entries answer one question, and it is not "Did the money move?"

It is "Does this cost belong to this period?"

Two directions, one problem

Cash and cost rarely move on the same day. Sometimes cash goes out early; sometimes the cost happens first and the invoice shows up weeks later. Accounting has a separate entry for each direction.

A prepaid expense is cash paid before the benefit is consumed. It goes on the balance sheet as a current asset, then releases into the income statement month by month as the business actually uses it.

An accrued expense is a cost already incurred with no invoice and no payment yet. It goes on the income statement now and creates a current liability for what is owed.

Fixing Hollis's January

Her entry when the check cleared should have parked the premium as an asset, not an expense:

Dr Prepaid Insurance $18,600 / Cr Cash $18,600 (Dr = debit, Cr= credit)

Then each month, one twelfth of the benefit gets consumed:

Dr Insurance Expense $1,550 / Cr Prepaid Insurance $1,550

The math behind that release is worth memorizing because it applies to every prepaid item on the schedule:

Monthly amortization = Total prepayment ÷ Number of periods covered

$18,600 ÷ 12 = $1,550 per month.

Here is what the prepaid asset looks like as it unwinds:

January's loss disappears. Insurance costs the gym $1,550 in January, the same as it costs in July, because that is what the gym actually used.

The other side of the calendar

Two weeks after the insurance fix, Hollis ran into the opposite problem. Her pay period closed on the 26th, but staff worked through the 31st. Five days of wages sat unrecorded, and the electric bill covering January would not arrive until the middle of February.

Both costs were incurred. Neither had been paid or billed. So both get accrued on the last day of the month:

Dr Wage Expense $4,300 / Cr Wages Payable $4,300

Dr Utilities Expense $2,100 / Cr Utilities Payable $2,100

The wage figure comes from a straightforward proration rather than a guess:

Accrued wages = Average daily payroll × Workdays after the last pay date

Estimating utilities from the prior month's actual bill is standard practice. When the real invoice lands at $2,180, the extra $80 gets booked to Utilities Expense at payment. Small variances are normal. Large ones mean the estimate method needs work.

Accrued expenses and accounts payable are not twins

New bookkeepers park accruals in accounts payable because both are liabilities. The difference is documentation. Accounts payable exist because a vendor invoice arrived and the amount is confirmed. An accrued expense exists because judgment says a cost happened, and no paperwork has caught up.

Keeping them separate tells anyone reading the balance sheet which liabilities are confirmed and which are estimates. Once the invoice arrives, the accrual clears into payables, then payables clear into cash.

The reversal step almost everyone skips

Post an accrual in January, then let the February invoice hit expense again, and the same cost lands twice. The reversal prevents it. On the first day of the new period, debit the accrued liability and credit the expense account, then let the real invoice post normally. QuickBooks and NetSuite both let you flag an entry to auto-reverse.

Fixed, level accruals that repeat at the identical figure each month usually skip reversal, since the amount simply rolls forward.

Set a materiality threshold too. Accruing a $40 subscription every month costs more staff time at close than the accuracy is worth. Pick a dollar floor, document it, and stay consistent so the policy holds up in review.

Where prepaid balances go stale

The mirror error to a missed reversal is a prepaid asset nobody ever releases. An annual software license gets booked correctly in month one, the schedule never gets touched again, and eighteen months later the balance sheet still carries an asset for a subscription that expired. Expenses come out understated, profit comes out overstated, and the overstatement compounds quietly across every period it survives.

A prepaid schedule fixes this in one screen. One row per item, showing what was paid, the period it covers, the monthly release, and the running balance. At any month-end the total on that schedule should tie to the prepaid line on the balance sheet. When a lender or an auditor asks what sits in prepaid assets, that reconciliation is a thirty-second answer instead of a two-day reconstruction.

Why any of this is worth the effort

Under accrual accounting, expenses belong in the period that produced the revenue they helped earn. The IRS requires businesses above an inflation-indexed gross receipts threshold to use the accrual method, with the base set at $25 million under the Tax Cuts and Jobs Act and adjusted annually. Below that line, cash basis is often available, and plenty of small operators use it.

Hollis was nowhere near $25 million. She still needed the entries, because a gym that looks unprofitable in January and suspiciously profitable in November cannot be managed, priced, or borrowed against.

Her fix took twenty minutes: one prepaid schedule with a row for insurance, the trade association dues, and the annual booking software, plus a month-end list of costs incurred but not yet billed.

The check she wrote in January was never a January cost. It was twelve monthly costs on one date.