Quick fact: Prepaid expenses are recorded as assets as the benefit is to be received. Accrued expenses are liabilities as the business has incurred the cost but has not yet paid for it.

Companies don’t always pay their expenses in the month that they use the service.

Occasionally the payment happens before months in advance of the actual expense. Other times the business has got the service and the invoice hasn’t arrived yet.

The two situations have to be accounted for separately.

In accrual accounting, the expense is recognised when it's incurred rather than when the cash leaves the bank account.

This is in accordance with the matching principle (a principle which allows you to record expenses in the period to which they relate).

Understanding Prepaid Expenses and Accrued Expenses is key to the preparation of financial statements, VAT records and Corporate Tax calculations.

Quick Answer

Prepaid expenses are payments made by a company for services which have not yet been received and are therefore initially recorded as an asset. Accrued expenses are the other way around. They are a liability as the cost has been incurred but not yet paid. Both of these are used to ensure that expenses are recorded in the correct accounting period.

What Are Prepaid Expenses?

Quick Answer: Prepaid expenses are payments made in advance for goods or services which the company expects to receive or use in a future accounting period.

The monies have been paid, the outlay has not yet been fully incurred.

The unutilised portion is recorded as an asset as the business still has a benefit to receive from that payment.

Prepaid expenses are normally shown as current assets on the balance sheet if the benefits are expected to be consumed within 12 months or within the normal operating cycle.

Typical prepaid expenses are:

Insurance premiums: Prepaid annual insurance coverage.

Office rent: Paid several months in advance.

Subscriptions: Payments made in advance to a business for services.

Software licenses: Software fees paid annually in advance.

One key point of distinction: paying early doesn’t in itself create a prepaid expense. The payment has to be for a benefit to be received in the future.

Accounting Treatment for Prepaid Expenses

Accounting rule: An advance payment is initially recorded as an asset. The appropriate amount is then transferred to expense as the benefit is received.

For instance a company in Dubai pays AED 24,000 for 12 months office insurance.

The full amount is paid up front, the cover is for the full year.

Initial Journal Entry

When the insurance premium is paid by the company:

Account	Debit (AED)	Credit (AED)
Insurance Prepaid	24,000
Bank/Cash		24,000

This is a payment that reduces cash and creates a prepaid asset.

The company hasn't yet booked the full AED 24k as an expense.

Adjusting Entry for Consumption of Benefit

The monthly insurance cost is:

AED 24,000 divided by 12 is AED 2,000.

At the end of each month the accountant writes:

Profile	Debit (AED)	Credit (AED)
Insurance expense	2,000
Prepaid insurance		2,000

AED 6,000 will be recognised as expense over the next three months.

The other AED 18,000 is still on the balance sheet as prepaid insurance.

This is carried on until the full premium has been amortised.

What Are Accrued Expenses?

Quick Answer: Accrued expenses are expenses which have been incurred but not yet paid (or not yet recorded via the normal billing process).

Here the business gets the benefit first and pays later.

Even if the invoice itself isn't yet available, the expenditure is in respect of the accounting period in which it was incurred.

Accrued expenses are generally recorded as current liabilities as the company has already received the goods or services and so owes money for them.

Examples of common ones are:

Wages payable: Salaries earned by employees but not yet paid.

Utilities: Electricity or water used prior to billing.

Interest payable: Interest accrued on loans outstanding.

Taxes due: Taxes that have been incurred but not yet paid.

Don't confuse accrued expenses with provisions. An accrual is typically for a more certain obligation as to amount or time.

Accrued expenses accounting treatment

Accounting rule: when the expense is incurred, record the expense and the liability (regardless of when the payment is made).

Consider an Abu Dhabi company with AED 15,000 of unpaid employee salaries at the end of September.

The staff have done their bit, payment will be in October.

That salary expense is still going to be in the September statements.

Journal Entry for Adjusting

The accountant makes an entry on September 30:

Account	Debit (AED)	Credit (AED)
Cost of Labor	15,000
Salaries Payable		15,000

The cost will have an impact on September’s profit.

Salaries payable are a current liability until they are paid.

Entry to Settlement

When the company pays employees in October :

Profile	Debit (AED)	Credit (AED)
Salaries Payable	15,000
Bank/Cash		15,000

The liability is eliminated.

Prepaid Expenses vs Accrued Expenses: Main Differences

Key difference: Prepaid expenses are expenses which have been paid in advance of the benefit being received. Accrued expenses are expenses that have been incurred but not yet paid, with the benefit having been received.

Basis	Prepaid Costs	Expenses Incurred
The Nature	Future economic profit	Payment obligation up to date
Cash timing	First payment is made	Pay Later
Classification in the balance-sheet	Current asset typically	Current liability, normally
Initial entry	Dr Prepaid Expenses, Cr Cash	Debit Accrued Liability, Credit Expense
Impact on Financial Statement	Expenses recognized result in a reduction of assets	Liabilities increase when expenses are incurred and decrease when they are paid

Both treatments have an impact on profit but they have a very different impact on the balance sheet.

A prepaid expense is a benefit which hasn't yet been consumed. Accrued expenses are liabilities which haven't yet been paid.

Why Proper Treatment is Important

Important caveat: Getting the expenses wrong will result in distorted profitability, distorted asset values, and distorted outstanding liabilities even if your bank transactions are recorded correctly.

Accurate Financial Statements

Suppose a company pays a full year's worth of insurance and then expenses it all in January.

There are no insurance expenses recognised which results in an overstatement of profit in January and an understatement of profit in the subsequent months.

Accrual adjustments charge the expense to the correct periods.

Matching Convention

Under accrual accounting costs are recognised in the period to which they relate.

This gives management a much clearer picture of the month on month performance of the business rather than having the payment dates determine the reported expenses.

Audit & Compliance

Companies in the UAE preparing their financial statements under IFRS need to apply the correct rules of expense recognition and classification.

Audit adjustments may be required in the case of incorrect accruals or prepayments.

The accounting treatment is also relevant for Corporate Tax purposes, though the tax deductibility will be subject to the UAE tax legislation.

The VAT treatment should be considered in isolation, in particular with regard to the validity of the tax invoices and the input tax recovery requirements.

Better Business Choices

The timing of the expenses can have an impact on the view of management as to the profitability of the business.

Prepaid assets can be overstated which means the financial position can appear better than it really is.

Accrued expenses missing will result in an understatement of liabilities and an overstatement of profit.

Accountants will pick up on these errors during their normal month end reviews prior to the financials being finalised.

Conclusion

Prepaid expenses and accrued expenses are the same in appearance but work in exactly opposite ways in accounting terms.

For UAE businesses it's all about the accounting (i.e. the correct recognition of costs in the right accounting periods, the production of reliable financial statements and the avoidance of misleading profit figures).

The practical rule is simple really: record the expense when it's incurred rather than when it's paid.

FAQs

How do you easily spot prepaid and accrued expenses?

See when the payment is made. Prepaid expenses: if your company pays for a service in advance it’s a prepaid expense. An accrued expense is one for which you've received the service but not yet paid. Typical examples would be annual insurance paid in advance and monthly electricity bills which haven't yet been paid.

Are prepaid expenses normal expenses in the end?

Yes. As the business uses the service over time the prepaid expense becomes a recurring expense. So if you pay AED 12,000 for a year of software subscription for example, rather than write off the full AED 12,000 as an expense in the period you pay it, you would allocate the AED 1,000 per month over the subscription period.

What if a business fails to record its accrued expenses?

Your profit may in fact be higher than it actually is. Take the example of at month end your company owes AED 8,000 in salaries which you don't record. That amount won't be in your expenses or your liabilities and that can cause problems when you're looking at the financial statements or reviewing your monthly profit.

How frequently should companies be reviewing their prepaid expenses and accruals?

Ideally each month prior to you closing the books you'd look at which of the prepaid items have been used and which of the unpaid expenses are for that month. Start with rent, insurance, salaries and the utility bills. Regular reviews like this will prevent small accounting errors from simply carrying forward into the next reporting period.

Prepaid Expenses vs Accrued Expenses: Accounting Treatment and Examples

What Are Prepaid Expenses?