Prepaid expenses, accrued expenses and deferred revenue

By Junaid IqbalUpdated 1 August 20264 min read

CA Finalist, ACCA FinalistEditorial team: Chartered Advisory Team of Chartered Accountants

Quick answer: These adjustments match activity to the right period: a prepaid expense is paid now and used later, an accrued expense is incurred now and paid later, and deferred revenue is received now but earned later, so it is a liability until earned.

Prepaid expenses, accrued expenses, and deferred revenue are the entries that make accrual accounting tell the truth about a period. They exist to solve the same problem from different angles: cash and economic activity do not always happen in the same month, and profit should follow the activity, not the cash. This guide explains all three and how each is recorded.

The problem they solve

Under accrual accounting, income and expenses belong in the period they are earned or incurred, not the period the cash moves. But businesses routinely pay ahead, get billed late, or take money upfront. These three adjustments realign the accounts with reality:

Prepaid expenses — paid now, used later.
Accrued expenses — incurred now, paid later.
Deferred revenue — received now, earned later.

Each one moves a figure out of the period where the cash happened and into the period where the economic activity happened. Getting them right is what separates a profit figure that reflects the business from one that just echoes the bank statement.

Prepaid and accrued expenses

A prepaid expense is a payment for a future benefit — annual insurance, rent paid in advance, a yearly software licence. Because the business has paid for something it will use over time, it starts as an asset, and a portion is moved to expense each period as the benefit is consumed. An accrued expense is the mirror image: a cost the business has incurred but not yet paid or been billed for — wages earned before payday, utilities used but not yet invoiced. It is recorded as an expense with a matching liability, so the cost lands in the period it belongs to. One defers a paid cost into the future; the other pulls an unpaid cost into the present.

Worked illustration. A business pays $12,000 for a year of insurance in January. Rather than a $12,000 January expense, it records a $12,000 prepaid asset and moves $1,000 to expense each month, so each month bears its fair share. Separately, staff earn $4,000 of wages in the last week of March but are paid in April: the business accrues a $4,000 expense and liability in March, so March's profit reflects the work done that month.

Deferred revenue

Deferred revenue — also called unearned revenue — is the income-side version. It is money the business has received before it has earned it: an upfront annual subscription, a deposit for work not yet done, a retainer paid in advance. Crucially, it is a liability, not income, when received, because the business still owes the customer the service. It is moved into income gradually as the work is delivered. Recording the whole upfront receipt as income immediately would overstate revenue in that period and leave nothing to recognise in the periods when the business actually does the work — flattering one month and starving the rest.

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Where they fit

These adjustments are the heart of a proper period-end close — the entries that turn a rough set of books into accounts that reflect the period honestly. They overlap with other timing questions in the books: how significant loan fees are spread, and how inventory costs are matched to sales. For tax, whether and how these items are recognised can depend on the accounting method and specific rules, so where amounts are material it is worth confirming the treatment rather than assuming the book approach carries straight through.

Confirm before you rely on this. The accounting here is standard practice; the tax recognition of prepaid, accrued and deferred items depends on your method and rules set by the IRS, which can change. Confirm the current position from IRS Publication 538 or a licensed US professional.

Sources

This guide is written against the official and clearly labelled professional references below. Rates, thresholds and portal procedures change between reviews, so open the primary source before relying on a figure.

Questions people also ask

What is a prepaid expense?

A prepaid expense is a cost paid in advance for something the business will use over time, such as annual insurance or rent paid ahead. It starts as an asset because the business has paid for a future benefit, and it is moved to expense gradually as that benefit is used up. Recording the whole payment as an immediate expense would misstate the period it was paid in.

What is an accrued expense?

An accrued expense is a cost the business has incurred but not yet paid or been billed for — for example, wages earned by staff before payday, or utilities used but not yet invoiced. It is recorded as an expense with a matching liability, so the cost lands in the period it belongs to rather than the later period when it is paid.

What is deferred revenue?

Deferred (or unearned) revenue is money a business has received before it has done the work or delivered the goods — such as an upfront annual subscription. It is a liability, not income, until it is earned, because the business still owes the customer the service. It is moved into income gradually as the service is delivered.

Scope note: General educational information for Pakistan, not a legal opinion or a substitute for advice based on your documents. Law, notifications, portal procedures and individual facts can change the result.

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