Prepaid expenses, accrued expenses, and depreciation are the three timing adjustments that accrual accounting uses to push a cost into the period that actually benefits from it. A prepaid expense is cash paid before the benefit is used, an accrued expense is a benefit used before cash is paid, and depreciation spreads a long-lived asset’s cost across the years it earns revenue. Each has its own book entry, its own IRS treatment, and its own way of going wrong.
Prepaid Expenses
A prepaid expense is a cost you’ve paid for something you haven’t consumed yet. Writing a check for next year’s insurance or six months of rent doesn’t reduce profit on the day the payment clears. It simply swaps cash for a different asset: the right to future coverage or occupancy. On the balance sheet, cash goes down and a prepaid asset goes up by the same amount. Nothing hits the income statement.
The expense trickles in later. Pay $12,000 on January 1 for a twelve-month policy, and each month-end you record $1,000 of insurance expense and reduce prepaid insurance by $1,000. By December 31 the asset is zero and the full $12,000 has flowed through the income statement in equal installments. The entry each month is a debit to Insurance Expense and a credit to Prepaid Insurance. Rent, maintenance contracts, software subscriptions, and bulk supply purchases all follow the same pattern.
Multi-Year Prepayments
When the prepayment covers more than twelve months, the portion beyond a year moves to long-term assets. A $36,000 three-year software license puts $12,000 in current assets and $24,000 in long-term prepaid assets, with $1,000 shifting to expense every month. Cloud subscription contracts follow the same logic: the buyer recognizes expense as the service is delivered, regardless of when the invoice was paid.
The 12-Month Rule for Tax Purposes
GAAP always spreads the expense across the benefit period. The IRS offers a shortcut. Under Treasury Regulation 1.263(a)-4(f), you can deduct a prepaid cost immediately if the benefit doesn’t extend beyond 12 months after it begins and doesn’t run past the end of the tax year following the year of payment.1eCFR. 26 CFR 1.263(a)-4 – Amounts Paid to Acquire or Create Intangibles Both conditions must be met. Prepay $12,000 of rent on December 31 for the following calendar year and it qualifies. A 15-month insurance policy paid on October 1 fails the first test, and the cost has to be capitalized and amortized over the full coverage period for tax purposes.
When the shortcut applies, the financial statements still show monthly recognition while the tax return takes the full deduction in year one. That gap gets tracked in the tax provision workpapers.
Accrued Expenses
Accrued expenses run in the opposite direction. Here the business has already consumed something or incurred an obligation but hasn’t paid. The classic case is wages earned in the last days of a month when payday falls in the next month. The labor was performed, the cost belongs to the current period, and the expense and liability have to be recorded even though no cash has moved.
The adjusting entry debits an expense (Wage Expense) and credits a liability (Wages Payable). Expenses rise and current liabilities rise together. When the check is finally cut the next period, the entry clears the liability: debit Wages Payable, credit Cash. The expense stays put in the period where it belongs.
What a Payroll Accrual Actually Contains
Payroll is the most common accrual and the messiest. The month-end liability isn’t just gross wages owed to employees. The employer also owes its share of FICA: 6.2% for Social Security and 1.45% for Medicare, totaling 7.65% of covered wages.2Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates The Social Security portion stops at the annual wage base, which is $184,500 for 2026.3Social Security Administration. Contribution and Benefit Base Federal unemployment tax and applicable state unemployment taxes need to be accrued too. The balance sheet should show the full obligation to employees and tax agencies, not just the net paychecks.
The 2½-Month Rule for Bonuses
Businesses often authorize year-end bonuses in December but pay them in the new year. The IRS lets you deduct the bonus in the year the obligation is fixed, but only if payment happens within 2½ months after the tax year ends. For calendar-year businesses, that deadline is March 15.4Internal Revenue Service. Revenue Ruling 2007-12 – General Rule for Taxable Year of Deduction Miss the window and the deduction shifts to the year of payment. Bonuses to related parties like significant shareholders don’t get this flexibility. Those deductions are automatically deferred until the employee receives the cash.
The All-Events Test
For any accrual to be deductible, the IRS requires the all-events test. Every event that creates the liability must have occurred, the amount must be determinable with reasonable accuracy, and economic performance must have taken place.5Internal Revenue Service. Publication 538 – Accounting Periods and Methods Economic performance generally means the service was rendered or the property was delivered. Signing a contract for future services doesn’t get you a current deduction. The work has to be done, or at least substantially underway.
Beyond payroll, the routine accruals are interest on loans, utilities consumed but not yet billed, and professional fees for work completed before the invoice arrives.
Depreciation
When a business buys equipment, a vehicle, or a building, the whole cost doesn’t belong in one year. The asset generates revenue for years, so its cost gets spread across those years. Depreciation is that allocation. It’s a non-cash expense: no money leaves the bank, but reported profit drops and the asset’s carrying value on the balance sheet falls.
Straight-Line for the Books
Under GAAP, most businesses depreciate on a straight-line basis. Subtract estimated salvage value from the cost, then divide by expected useful life. A $50,000 machine with a $5,000 salvage value and a five-year life generates $9,000 of depreciation expense per year. The cost basis includes freight, installation, and any other cost needed to get the asset operational, not just the sticker price.
Each year debits Depreciation Expense and credits Accumulated Depreciation, a contra-asset account that offsets the original cost. After three years, the machine’s book value is $50,000 minus $27,000, or $23,000. The historical cost stays visible while the contra account shows how much has been expensed.
MACRS on the Tax Return
For tax purposes, the IRS generally requires the Modified Accelerated Cost Recovery System (MACRS) for property placed in service after 1986.6Internal Revenue Service. Topic No. 704 Depreciation MACRS assigns each asset type a recovery period (5 years, 7 years, 15 years, and so on) and uses accelerated methods that front-load the deductions. Office furniture, for instance, is 7-year property but produces larger deductions in the first three years than the last four. Businesses report MACRS depreciation on Form 4562.7Internal Revenue Service. About Form 4562, Depreciation and Amortization
Section 179 Expensing
Section 179 lets a business deduct the full purchase price of qualifying property in the year it’s placed in service instead of depreciating it over multiple years.8Office of the Law Revision Counsel. 26 US Code 179 – Election to Expense Certain Depreciable Business Assets The One Big Beautiful Bill Act raised the ceiling significantly. The statutory base is now $2,500,000, phasing out dollar-for-dollar once qualifying property placed in service exceeds $4,000,000. The IRS confirmed these exact figures for tax years beginning in 2025.9Internal Revenue Service. Instructions for Form 4562 (2025) The thresholds are adjusted annually for inflation. One catch: the Section 179 deduction can’t exceed the business’s taxable income from active operations that year.
100% Bonus Depreciation After the OBBBA
Bonus depreciation had been phasing down, dropping to 80% in 2023, 60% in 2024, and 40% for early 2025. The One Big Beautiful Bill Act reversed that. For qualified property acquired after January 19, 2025, first-year bonus depreciation is permanently 100%.6Internal Revenue Service. Topic No. 704 Depreciation Unlike the temporary 100% rate under the 2017 Tax Cuts and Jobs Act, this version doesn’t phase down. Notice 2026-11 provides the guidance, including removal of the earlier requirement that eligible property be placed in service before 2027.10Internal Revenue Service. Treasury, IRS Issue Guidance on the Additional First Year Depreciation Deduction Amended as Part of the One Big Beautiful Bill
The stacking order matters. Bonus depreciation is taken after any Section 179 deduction and before regular MACRS. Many businesses use both: Section 179 for the first tranche of asset costs up to the deduction limit, then bonus depreciation on the remainder.
The Deferred Tax Liability
Because most businesses use straight-line on the books and accelerated methods on the return, the two sets of numbers diverge every year. In the early years tax depreciation exceeds book depreciation, so taxable income sits below financial income. The gap reverses later, when book depreciation continues but the tax deductions have already been taken. Under ASC 740, this temporary difference produces a deferred tax liability on the balance sheet, measured using the enacted tax rate expected to apply when the difference reverses.
What Happens When These Entries Are Wrong
Skipping the adjusting entries produces predictable damage. Failing to record accrued wages understates both expenses and liabilities, making profit look higher and debts look lower. Neglecting to expense a portion of a prepaid asset inflates the asset and overstates income. Omitting depreciation leaves long-term assets at their purchase price forever and overstates net income every year the entry is missed.
When those misstatements flow through to the tax return, the IRS can impose an accuracy-related penalty of 20% on the underpaid tax attributable to negligence or a substantial understatement.11Internal Revenue Service. Accuracy-Related Penalty For individuals, a substantial understatement exists when the understated tax exceeds the greater of 10% of the correct tax or $5,000. Interest runs on top of the penalty. For the first quarter of 2026, the IRS charges 7% on corporate underpayments.12Internal Revenue Service. Interest Rates Remain the Same for the First Quarter of 2026
The mistakes that draw penalties are almost always timing errors: deducting a prepaid cost before the benefit period starts, claiming an accrual that hasn’t met the all-events test, or applying the wrong depreciation method or recovery period. The IRS also scrutinizes Section 179 elections that exceed the business income limitation and bonus depreciation claimed on property that doesn’t meet the current acquisition date rules. Clean adjusting-entry processes and documented support for each deduction are what keep these problems from arising.