Prepaid expenses, accrued expenses, and depreciation are the three timing adjustments that keep accrual-basis books honest: prepaid expenses spread a cash payment forward across the periods that will actually use it, accrued expenses pull a cost backward into the period that incurred it before cash moves, and depreciation allocates the cost of a long-lived asset across the years it produces revenue. Each has a GAAP treatment for financial statements and a separate IRS treatment for the tax return, and the gap between the two is where most mistakes and penalties happen.
Prepaid Expenses: Paying Now, Using Later
A prepaid expense starts as an asset, not an expense. When you pay $12,000 on January 1 for a 12-month insurance policy, cash goes down by $12,000 and a prepaid insurance asset goes up by the same amount. Nothing hits the income statement that day. Each month you debit Insurance Expense $1,000 and credit Prepaid Insurance $1,000 until the asset zeros out on December 31. The same pattern covers rent paid in advance, maintenance contracts, software subscriptions, and bulk supplies.
Prepayments that stretch past twelve months get split on the balance sheet. A $36,000 three-year software license puts $12,000 in current assets and $24,000 in long-term prepaid assets, with $1,000 moving to expense each month. Cloud subscription contracts follow the same ratable recognition regardless of when you paid the invoice.
The 12-Month Rule for Tax
GAAP always requires spreading the expense over the benefit period. The IRS gives you 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 it 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 tests have to be met.
A $12,000 rent payment made on December 31 for the following calendar year qualifies. A 15-month insurance policy paid on October 1 does not, because the benefit extends beyond 12 months, so you have to capitalize and amortize it for tax purposes just like you do for the books. When the shortcut is used, the tax return shows the full deduction in year one while the financial statements still show monthly expense. That permanent-looking gap gets tracked in the tax provision workpapers.
Accrued Expenses: Incurred Now, Paying Later
Accrued expenses run the opposite direction. You’ve already consumed something or become obligated to pay, but no cash has moved. The adjusting entry debits an expense and credits a liability. When the payment finally clears, you debit the liability and credit cash, and the expense stays in the period where the economic activity happened.
Payroll Is More Than Gross Wages
Payroll is the most common and most complex accrual. The month-end liability isn’t just the gross paycheck owed to employees. The employer also owes its share of FICA: 6.2% Social Security and 1.45% 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 FUTA and any applicable state unemployment tax also need to be accrued. The balance sheet has to reflect the full obligation to employees and tax agencies, not just the net check.
The All-Events Test
To deduct an accrued expense, the IRS requires the all-events test: every event that fixes the liability has occurred, the amount is determinable with reasonable accuracy, and economic performance has taken place.4Internal Revenue Service. Publication 538 – Accounting Periods and Methods Economic performance generally means the service was rendered or the property provided. Signing a contract for future services isn’t enough. The work has to be done, or at least substantially underway.
The 2½-Month Rule for Bonuses
Year-end bonuses authorized in December but paid in the new year are deductible in the accrual year only if paid within 2½ months after the tax year ends. For a calendar-year business, that deadline is March 15.5Internal Revenue Service. Revenue Ruling 2007-12 – General Rule for Taxable Year of Deduction Miss it, and the deduction moves to the year of payment. Bonuses to related parties, such as significant shareholders, never get this flexibility; those deductions are automatically deferred to the year the recipient receives the cash.
Other Accruals
Interest on loans, utilities consumed but not yet billed, and professional fees for completed work all follow the same pattern. A $100,000 loan at 6% generates roughly $500 of interest each month, accrued at period end with a debit to Interest Expense and a credit to Interest Payable, cleared when the payment goes out.
Depreciation: Spreading an Asset’s Cost Over Its Life
When you buy equipment, a vehicle, or a building, the cost belongs to every year the asset produces revenue, not just the year of purchase. Depreciation is how you allocate it. No cash moves when you record depreciation, but reported profit falls and the asset’s carrying value drops.
Straight-Line for the Books
Most businesses use straight-line depreciation on their GAAP financial statements. Subtract estimated salvage value from cost, then divide by useful life. A $50,000 machine with a $5,000 salvage value and a five-year life generates $9,000 of depreciation each year. Cost basis includes freight, installation, and anything else needed to get the asset operational. The annual entry debits Depreciation Expense and credits Accumulated Depreciation, which offsets the asset’s original cost on the balance sheet.
MACRS for the Tax Return
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 to a recovery period (5 years, 7 years, 15 years, and so on) and front-loads deductions into the early years. Office furniture, for instance, sits in the 7-year class but produces larger deductions in years one through three than in years four through seven. Depreciation gets reported on Form 4562.7Internal Revenue Service. About Form 4562, Depreciation and Amortization
Section 179 Expensing
Section 179 lets you deduct the full purchase price of qualifying property in the year it’s placed in service instead of depreciating it over the recovery period.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, with the deduction phasing out dollar-for-dollar once qualifying property placed in service exceeds $4,000,000. The IRS confirmed these figures for tax years beginning in 2025.9Internal Revenue Service. Instructions for Form 4562 (2025) The thresholds are indexed for inflation. One important limit: the Section 179 deduction can’t exceed the business’s taxable income from active operations that year.
Bonus Depreciation Is Back to 100%
Bonus depreciation had been phasing down since 2023, hitting 80% in 2023, 60% in 2024, and 40% for early 2025. The One Big Beautiful Bill Act reversed course. For qualified property acquired after January 19, 2025, first-year bonus depreciation is permanently 100%, with no scheduled phasedown.6Internal Revenue Service. Topic No. 704 Depreciation 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 Property acquired before January 20, 2025 still follows the old phasedown rates.
Bonus depreciation comes after any Section 179 deduction and before regular MACRS. Many businesses stack both: Section 179 up to the deduction limit, then 100% bonus on whatever’s left.
The Deferred Tax Liability
Because straight-line runs on the books and accelerated methods run on the tax return, the two systems show different amounts of depreciation expense each year. In early years, tax depreciation is higher, so taxable income is lower than book income. That flips in later years. Under ASC 740, the temporary difference sits on the balance sheet as a deferred tax liability, measured at the enacted rate expected to apply when the difference reverses.
Why These Entries Matter and How Reversing Entries Help
Skipping any of these adjustments distorts the books in predictable ways. Missing accrued wages understates expenses and liabilities, making profit and net worth both look better than they are. Failing to expense a portion of a prepaid asset inflates assets and overstates income. Omitting depreciation leaves long-term assets frozen at purchase price and overstates net income every year the entry is skipped.
Reversing entries are an optional cleanup tool. Posted on the first day of a new period, they mirror the prior period’s accrual so that when the actual cash transaction lands, no one has to remember what was already booked. If you accrued $15,000 of payroll on March 31, a reversing entry on April 1 wipes the accrual so the full April payroll runs through normally without manual splitting. In high-volume environments where different people handle the close and daily entries, this prevents double-counting.
What Getting It Wrong Costs
Timing errors that flow through to the tax return can trigger the accuracy-related penalty of 20% on the portion of underpayment 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 the IRS sees most often are timing mistakes: deducting a prepaid expense before the benefit period has begun, claiming an accrual that hasn’t cleared the all-events test, applying the wrong MACRS recovery period, exceeding the Section 179 business income limitation, or claiming 100% bonus depreciation on property that was actually acquired before January 20, 2025. Clean adjusting entry processes and contemporaneous documentation of the basis for each deduction are the reliable defense.