Prepaid and accrued expenses: contracts, bonuses and cut-off
How an annual contract, a bonus being earned and December's unbooked charges reach the P&L in the right month, with reversing entries.
Two kinds of cost reach the profit and loss in a different month than the cash. A prepaid is paid first and used later. An accrued expense is used first and paid later. The schedules lesson ran the insurance, the software and the power bill. This one applies them to the spend that is not a vendor bill: an annual contract on a card, a bonus that is being earned, and the charges nobody has booked at the close.
An annual contract
On November 1, 2026 Northwind pays $2,400 for a year of a tool. The cash left on one day; the benefit arrives over 12 months. Amortized evenly it releases $200 a month. At December 31, 2026 two months are released, $400, and $2,000 is still a prepaid.
Annual contract, paid up front
| Account | Debit | Credit |
|---|---|---|
| 1410Prepaid software | 2,400.00 | |
| 1000Cash | 2,400.00 | |
| Balanced | 2,400.00 | 2,400.00 |
Paid on the first, as a prepaid.
Release one month of the contract
| Account | Debit | Credit |
|---|---|---|
| 6800Software expense | 200.00 | |
| 1410Prepaid software | 200.00 | |
| Balanced | 200.00 | 200.00 |
Each month end, one twelfth.
Tax has its own view of a prepayment. Under the 12-month rule a payment for a benefit that does not run past 12 months, or past the end of the next tax year, need not be capitalized. This contract is inside it; a 24-month term would be outside it. Whether the deduction then falls in the year paid also depends on whether the company is on the cash or the accrual method for tax, so ask your preparer. The books defer the cost either way.
Accruing a bonus
The operations manager's bonus plan runs October 1, 2026 for 12 months. Her target is $6,000 and the plan expects 85 percent attainment, so the expected payout is $5,100. Under the accrual basis the cost is recognized as the months pass, provided the payout is probable and can be estimated, not when the check is cut, and the employer's share of Social Security and Medicare on it is accrued with it. At December 31, 2026, 3 of 12 months are done.
Bonus earned through December, with the employer's payroll tax
| Account | Debit | Credit |
|---|---|---|
| 6000Payroll expense | 1,275.00 | |
| 6100Payroll tax expense | 97.54 | |
| 2200Accrued liabilities | 1,372.54 | |
| Balanced | 1,372.54 | 1,372.54 |
Three months of accrual, shown as one entry.
When the bonus is paid it will not match the estimate. If it comes in at $5,400, the difference is not a prior-period error: it is a true-up, expensed in the month of payment, along with the change in the employer's payroll tax. The accrual is a best estimate, and the estimate was reasonable when it was made.
Bonus paid through payroll; the difference from the estimate is expensed now
| Account | Debit | Credit |
|---|---|---|
| 2200Accrued liabilities | 5,100.00 | |
| 6000Payroll expense | 300.00 | |
| Payroll cash and withholdings | 5,400.00 | |
| Balanced | 5,400.00 | 5,400.00 |
The payout, after twelve months of accrual.
Employer payroll tax on the bonus paid
| Account | Debit | Credit |
|---|---|---|
| 2200Accrued liabilities | 390.15 | |
| 6100Payroll tax expense | 22.95 | |
| 2100Payroll liabilities | 413.10 | |
| Balanced | 413.10 | 413.10 |
And the employer's tax on what was actually paid.
The spend nobody has booked
An expense belongs to the period it was incurred in. The day it was approved, submitted or paid does not matter. At December 31, 2026 four records sit around the close: two incurred in December and not yet booked, one booked in December that belongs to January, and one that is simply right. Cut-off is the work of putting each in its month, and it is what an auditor's search for unrecorded liabilities looks for.
Accrue December expenses not yet booked
| Account | Debit | Credit |
|---|---|---|
| Freight and delivery expense | 318.40 | |
| Travel expense | 207.35 | |
| 2200Accrued liabilities | 525.75 | |
| Balanced | 525.75 | 525.75 |
December gains the unbooked costs.
Hotel deposit belongs to January
| Account | Debit | Credit |
|---|---|---|
| Prepaid expenses | 450.00 | |
| Travel expense | 450.00 | |
| Balanced | 450.00 | 450.00 |
And sheds the deposit for a January trip, which is a prepaid.
Reverse the December accrual
| Account | Debit | Credit |
|---|---|---|
| 2200Accrued liabilities | 525.75 | |
| Freight and delivery expense | 318.40 | |
| Travel expense | 207.35 | |
| Balanced | 525.75 | 525.75 |
On the first day of January, the accrual comes out so the real bills book normally.
The month a cost belongs to is the month it was used, not the month it was approved or paid.
Finished this lesson?
Where this lesson's rules come from
The sources behind this lesson's requirements, by kind. Anything marked as a convention is ours, not the rule-maker's.
- Federal regulation
- Treas. Reg. §1.263(a)-4(f), the 12-month rule (opens in a new tab)A payment for a benefit of 12 months or less need not be capitalized for taxFree to read
- US GAAP
- ASC 340-10 (opens in a new tab)Other Assets and Deferred Costs — prepaid expensesFree after registration
- ASC 450 (opens in a new tab)ContingenciesFree after registration
- Conceptual framework
- CON 8, Introduction — as amended by Ch. 4, App. A (carrying forward CON 6, ¶139) (opens in a new tab)What accrual accounting is forFree to read
The full map is in US GAAP, and where these rules come from.
The words this lesson teaches
Each links to its glossary definition, which also names the authority behind it and the components that render it.
- Prepaid expenseCash paid before the benefit is consumed — an asset until it is. "Prepayment" is the UK and IFRS word for the same asset; a customer paying us early is a customer advance or deposit, a liability
- AccrualAn expense incurred, or revenue earned, before it is invoiced — recorded at period end so it lands in the right period
- Accrued liabilityAn obligation for goods or services received but not yet invoiced or paid — wages, interest, professional fees — recorded by an accrual
- Reversing entryAn entry dated the first day of the next period that exactly offsets a period-end accrual, so the real invoice can be coded normally without double-countingConvention
- CutoffRecording each transaction in the period in which it occurred — the boundary tested at every period endConvention
- True-upThe adjustment that replaces an estimate with the actual amount once it is known
- Unrecorded liabilities searchThe audit procedure of looking at payments made and bills received after period end, and at receipts with no bill, to find obligations that existed at the balance sheet date but were never recorded. Management runs the same search before close, because what it finds is accruedConvention
- AmortizationSpreading the cost of a finite-lived intangible, a prepaid or a debt discount over the periods it serves
In the founder glossary
This lesson’s ideas, explained for the founder running the company. Each has an entry in the founder glossary.
See also
- Schedules, accruals & roll-forwardsEvery balance sheet account needs a schedule behind it, and the schedule has to tie to the GL. Most accounting products ship a ledger and statements and leave the schedules in spreadsheets. That handoff is where closes break.
- Periods & the closeThe month-end close in accounting software: fiscal calendars, period states, cutoff, reconciliation vs tie-out, adjusting entries and restatement.
- Prepaid software releaseJournal entries for an annual software subscription: the payment, then the monthly release, with any rounding remainder spread one minor unit at a time across the last months.
- Prepaid & deferred releaseRelease a prepaid or deferred balance evenly or by days in each month.
- Journal entry for a prepaid software subscriptionWhen an annual software subscription is paid up front, debit Prepaid software and credit Cash (or Accounts payable). Each month-end, debit Software expense and credit Prepaid software for the days of service used that month.
- Journal entry for accrued expensesAt month-end, debit the expense and credit Accrued expenses for work received but not yet billed. Reverse the accrual on the first day of the next month, then book the vendor's bill as usual when it arrives.
- Journal entry for accrued wagesAt month-end, debit Wages and salaries and credit Accrued wages for the days worked since the last payday. On payday, reverse the accrual or debit Accrued wages for the part of the payroll it covers.
- Prepaid expense vs accrued expenseA prepaid expense is an asset: the cash went out before the cost was used. An accrued expense is its mirror, a liability for a cost already used but not yet paid or billed.
- Reversal vs reversing entryA reversal is a new entry that cancels a wrong posted entry, and both stay in the ledger. A reversing entry is planned: it undoes a month-end accrual on the first day of the next period so the vendor's bill can be booked normally.
- Accrued expenses vs accounts payable at month-endAP is a bill you’ve received; an accrued expense is a cost incurred before the bill arrives. When to accrue, and how reversing entries work, by example.
- Why startups should close their books every monthA monthly close turns a bank balance into numbers an investor, an auditor or a 409A firm will accept. What it is, and why it gets expensive to skip.
- AdjustingEntryFormTemplated by type. Auto-reverse defaults on for accruals.
- ScheduleTableOne shell, seven presets. Prepaids through debt.