How To Leverage Contracts for Prepaid and Accrual Accounting

Accounting teams frequently struggle with the efficient management of prepaids and accruals due to the complexities involved in tracking expenses across multiple accounting periods and ensuring precise financial reporting. Traditional methods for managing prepaids often rely on manual data entry upon receipt of an invoice and reconciliation during close. This is time-consuming and susceptible to errors. To achieve accurate accounting and financial reporting, a centralized view of prepaids and accruals is essential. 

By taking a contract approach, accounting teams can get that centralized view and automate the tracking and management of prepaids and accruals. Contracts serve as the backbone of numerous business transactions, outlining the terms and conditions that govern financial obligations including prepaid and accrued expenses. For example, when a contract stipulates payment upfront for a yearlong subscription, that payment will result in a prepaid asset. Or when a contract stipulates that services will be rendered but payment can be made up to 90 days in arrears, an accrued liability may need to be created. Taking a contract approach to prepaid and accrual accounting enhances completeness and accuracy while improving visibility into financial obligations for better cash flow management and budget forecasting.

Limitations of Traditional Methods

Traditional methods, including spreadsheets and ERP systems, encounter significant limitations in managing prepaid and accrual accounting.

Challenges with Spreadsheets

Spreadsheets are often time-consuming, manual, tedious, and susceptible to human error. They also lack scalability, an audit trail, and offer limited collaboration features. They are not typically an organized and referenceable repository of information.

Issues with ERP Systems

ERP systems typically utilize an invoice-based approach for prepaids. For instance, if you receive quarterly invoices over a three-year contract, you would set up prepaid amortization each time a new invoice payment is made—amounting to 12 repetitive tasks. This invoice-based approach becomes increasingly complex when payment amounts and timing vary due to irregular payment patterns (common in insurance contracts), complicating the accurate expensing of payments over the contract term.

An invoice-based approach solely focuses on the individual invoice, which can complicate compliance with GAAP principles that advocate for service contracts to be expensed as the service is received versus when an individual invoice payment is made. Additionally, if payments are delayed or an invoice is not received on time, these systems typically lack automated mechanisms to alert you to record an accrual, since the process usually relies on the presence of an invoice to set up expense amortization.

Why a Contract-Based Solution is Ideal

In invoice-based accounting, the prepaids are generated from actual invoices received by an organization. The following outlines the key differences between this approach and a contract-based solution:

Invoice-Based Accounting

• Prepaid Expenses: These are recorded when payment is made for goods or services in advance, with recognition based on the invoice payment date.
• Accruals: Occur when services have been received, but no payment has been made. In a system where the invoice triggers the accounting, accruals are often missed leading to the need for corrective entries.
• Challenges: This method may result in delays if invoices are received late, complicating the recording of expenses. Financial reporting may exhibit gaps due to the reliance on the timing of invoices.

The Importance of Contracts

Contracts serve as vital repositories of essential data for managing prepaids and accruals. They encompass crucial information, including payment schedules, terms, deadlines, and conditions, making them well-suited for automated prepaid and accrual management solutions. By adopting a contract-based approach, you can:

• Utilize a central repository for vendor contracts that facilitates automated calculations and journal entries that minimize the risk of errors while ensuring completeness and accuracy.
• Gain real-time visibility into your expenses and prepaid/accrual balances, enhancing financial planning and decision-making for your contracts and vendors.
• Improve accuracy and compliance to mitigate the risk of financial discrepancies and ensure adherence to regulatory requirements.

Contract-Based Accounting

Contract-based prepaid and accrual accounting relies on the terms specified in the overall contract instead of solely relying on the limited context of an individual invoice. Key features include:

• GAAP Compliance: Expenses are scheduled based on the contract term so that service contracts are expensed as the service is received regardless of when payment is made.
• Prepaids: Straight-line expenses, account numbers, and allocations are set up  for the contract, and can easily be reconciled to actual invoice payments made in the AP process
• Accruals: Anticipated according to the obligations outlined in the contract. A contract-based approach greatly reduces the risk of missing an accrual due to a late invoice. 

Advantages of Contract-Based Accounting

This approach offers enhanced completeness and accuracy. By shifting from an exclusive reliance on invoices to a greater view of the contract as a whole, contract-based accounting for prepaids and accruals ensures that financial records accurately reflect actual contractual obligations, thereby improving financial reporting and management. Adopting a contract-based solution, like FinQuery Contract Management (FCM), provides a more reliable framework for managing prepaids and accruals, leading to better financial outcomes. FCM was built with finance and accounting teams in mind and provides a comprehensive repository for all contracts—covering software, services, utilities, insurance, and more—enabling automated prepaid and accrual accounting as well as expense forecasting for those contracts.

Comparing Traditional Methods with a Contract-Based Solution

Conclusion 

Contracts hold valuable information that can significantly influence prepaid and accrual accounting. By leveraging contracts as a foundation for managing these aspects, organizations can achieve enhanced accuracy, control, and compliance while minimizing risks associated with traditional methods. Implementing a contract-based solution boosts efficiency by automating repetitive tasks, improves accuracy by reducing error risks, and ensures adherence to regulatory requirements. Choosing the right software is vital for the success of a contract-based solution. Look for software that offers features such as AI-enabled data entry, real-time reporting, and automated calculations to streamline the process and enhance completeness and accuracy.