One frequently tested topic on the CPA exam is accrual basis accounting. Companies that need to comply with GAAP (generally accepted accounting principles) have to use this method. GAAP represents the preferred rules of the road for the accounting industry.
Accrual basis accounting requires companies to recognize revenue when it's earned. The term earned generally means when a product is delivered or a service is completed. Expenses, on the other hand, are recognized when incurred. Incurred refers to when a cost is paid in cash or when a liability is created (accounts payable, for example). The accrual basis recognizes revenue and expense without regard to cash inflows and outflows.
Because accrual accounting and cash movements may be different, accountants post accrual entries. These entries are posted to ensure that the revenue or expense is posted in the proper period (month or year).
One common prepaid expense is for insurance premiums. Say that Reliable Plumbing pays $2,000 a month in insurance premiums on its trucks. On January 1, Reliable writes a $12,000 check for insurance premiums. The premiums are for the first six months of the year.
On January 1, the plumbing company debits (increases) prepaid insurance for $12,000 and credits (reduces) cash by $12,000. On February 1, the firm recognizes one month of insurance expense. The February journal entry is to debit (increase) insurance expense $2,000 and credit (decrease) prepaid insurance $2,000. The result is that the February insurance expense is posted to the proper month. As you can see, the accrual method doesn't record any expense when the insurance premiums are paid on January 1.