📌 **Month-End Closing Guide – Part 5: Prepaid & Accrued Expenses** **Overview:** Financial statements are prepared on an accrual basis, meaning transactions are recorded when they occur—not when cash is exchanged. Revenues are recognized when earned, and expenses are recorded when incurred (following the matching principle). This approach ensures that all expenses, including payroll, are accounted for in the same period as the related revenues. Compliance with GAAP or IFRS requires using accrual accounting to present a realistic view of a company’s obligations and future economic benefits. Without these adjustments, financial statements might understate liabilities (in the case of accrued expenses) or overstate assets (in the case of prepaid expenses). 🔹 **Impact on Financial Statements:** **✂️ Balance Sheet:** - **Prepaid expenses** are initially recorded as assets because they represent future benefits. - **Accrued expenses** create liabilities, reflecting obligations to pay in the future. **✂️ Income Statement:** - **Prepaid expenses** are gradually amortized, reducing net income as the benefit is realized. - **Accrued expenses** are recognized in the period when services are received, which decreases net income accordingly. --- ### **1️⃣ Prepaid Expenses** **Prepaid expenses** are payments made in advance for goods or services (e.g., rent, insurance, subscriptions, or service contracts). Under accrual accounting, only the portion consumed during the period is recognized as an expense, while the remaining balance is recorded as an asset. - **At the time of payment or upon receiving an invoice for future services:** - 📍 **Debit:** Prepaid Expense - 📍 **Credit:** Cash / Accounts Payable - **Monthly Amortization (recognizing the expense gradually):** - 📍 **Debit:** Relevant Expense Account - 📍 **Credit:** Prepaid Expense --- ### **2️⃣ Accrued Expenses** **Accrued expenses** represent costs incurred during the period but not yet invoiced. These obligations include utilities, interest, and salaries & wages (payroll), which must be recognized in the period services are rendered—even if cash payment occurs later. - **To record an accrued expense (e.g., utilities, interest, salaries & wages):** - 📍 **Debit:** Expense Account - 📍 **Credit:** Accrued Expense - **Upon receiving the vendor bill:** - 📍 **Debit:** Accrued Expense - 📍 **Credit:** Accounts Payable --- 💡 **Best Practices for Accurate Month-End Closing:** - **Adhere to Accrual Accounting:** Ensure that expenses are matched to the period in which they are incurred. - **Utilize ERP Systems:** Leverage technology to track and reconcile prepaid and accrued expenses accurately. - **Regular Reconciliation:** Compare recorded expenses with actual invoices before closing the books. Accurate expense recognition is crucial for reliable financial reporting and informed decision-making. 🚀 **Stay tuned for Part 6, where we’ll discuss Accrued Revenue and Unearned Revenue!**