Prepaid Expenses and Accrued Liabilities at Year End

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.

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.

Common questions

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.