Expenses incurred but not yet billed and paid are called accrued expenses. Whereas, expenses paid in advance are called prepaid expenses.
In cash basis of accounting, you’ll not see the terms accrued expenses or prepaid expenses. Entities simply record expense when they pay for the goods or services purchased. However, as per accrual basis of accounting, expenses are recorded when incurred regardless of whether cash is paid or not. So, paying cash is not the decisive factor for the timing of expense recognition.
Accrued expenses represent those expenses which have been incurred but have not been billed by the vendor and which have not been paid till the reporting date. For example, Ricardo Garments Inc. has used the electricity and water facilities in the month of December, however, the utility bill for the month of December will be received in January. As the expense is incurred in December, so it should be recorded in December as expense with a corresponding accrued liability. Similarly, wages of workers for the month of December will be processed and paid in January, but as they have worked in December, so their wages should be recorded as expense in the month of December.
Adjusting entries are usually required to record the accrued expenses at the end of an accounting period.
Cr. Accrued expense (liability)
When an entity pays an amount as consideration for some goods or services which will be received in future, that payment is not recorded as expense at the time of payment. It is recorded as a prepaid asset and is charged to income statement as expense when that good or service is received. For example, Ricardo Garments Inc. has paid an insurance premium of $3000 on 1 October. Term of insurance coverage is one year. It is recorded as prepaid insurance at the time of payment. At year end, three months have been passed, that means 25% of the total term of insurance has been passed, so 25% of $3,000 i.e., $750 should recorded as insurance expense and prepaid insurance should be reduced accordingly. Another common example of prepayments is prepaid rent which is also initially recorded as prepaid asset and is charged to income statement as rent expense over the term of prepayment.
Adjusting entries are usually required at the end of an accounting period to record expenses for the portion of prepaid assets that have been realized during that period.
Cr. Prepaid expense (an asset)
Following is a comparison of accrued expenses and prepaid expenses to better understand these concepts.