What accruals and prepayments are
The accruals idea is this: income and costs go into the year they are earned or used. The date the money moves does not decide it.
- Accrued expense
- A cost used this year that has not been paid or billed by the year end. It is also called an accrual.
- Prepaid expense
- A cost paid this year that will be used next year. It is also called a prepayment.
Both are put right with a year-end adjustment, so that profit is measured on twelve months of costs, no more and no less.
Costs that are too high make profit too low. Costs that are too low make profit too high. An accrual that is left out leaves costs too low. A prepayment that is left out leaves costs too high.
The year-end journal for each
| Adjustment | Debit | Credit | Shown as |
|---|---|---|---|
| Accrued expense | The expense account | Accrued expenses | Current liability |
| Prepaid expense | Prepaid expenses | The expense account | Current asset |
An accrual adds the cost to the expense account and records what is owed. Accrued expenses is a liability, because the business owes this money.
A prepayment takes the unused cost out of the expense account. Prepaid expenses is an asset, because the business has paid for something it has not used yet.
No money moves in either journal, so Bank is not used.
The idea works for income too. Income earned but not yet received is accrued income, a current asset. Money received for work still to do is deferred income, a current liability.
The steps in order
Do this for each expense account at the year end.
- Ask what period the bills and payments cover. Look for a bill that arrives after the year end, and for a payment that runs past it.
- Work out the cost of one month: the bill or the payment, divided by the months it covers.
- Count the months that fall before the year end. Write them out by name, so none is counted twice.
- For an accrual, multiply the monthly cost by this year's months that are not yet paid. That is the accrual.
- For a prepayment, multiply the monthly cost by the months after the year end. That is the prepayment.
- Write the journal: debit the expense and credit Accrued expenses, or debit Prepaid expenses and credit the expense.
- Work out the expense for the year. What was paid plus an accrual, or what was paid less a prepayment.
- On the first day of the new year, reverse each journal.
If no bill has arrived when the accounts are drawn up, the amount is estimated, and only for the months up to the year end.
The reversal matters. When the bill is paid in the new year, the whole of it is debited to the expense. The credit from the reversal cancels the part that was last year's cost.
A worked example of an accrual
Millrace Coffee is a café. Its accounting year ends on 30 June. The water bills paid during the year come to £1,410.00 and cover up to 31 March.
The next bill covers the 6 months from 1 April to 30 September. It arrives in October and is for £744.00.
One month costs £744.00 divided by 6, which is £124.00. April, May and June fall in this year, so the accrual is 3 months at £124.00: £372.00.
| Account | Debit £ | Credit £ |
|---|---|---|
| Water | 372.00 | |
| Accrued expenses | 372.00 |
The water expense for the year is £1,410.00 paid plus the accrual of £372.00, which is £1,782.00.
On 1 July the journal is reversed: debit Accrued expenses, credit Water. In October the bill of £744.00 is debited to Water in full. That leaves £372.00 in the new year, the cost of July, August and September.
A worked example of a prepayment
On 1 February Millrace pays £1,380.00 for a contract to service its coffee machines. The contract runs for 12 months, to 31 January. The whole payment was debited to Machine servicing.
One month costs £1,380.00 divided by 12, which is £115.00. July to January has been paid for and not yet used. That is 7 months at £115.00: a prepayment of £805.00.
| Account | Debit £ | Credit £ |
|---|---|---|
| Prepaid expenses | 805.00 | |
| Machine servicing | 805.00 |
The servicing expense for the year is £1,380.00 paid less the prepayment of £805.00, which is £575.00: the five months from February to June.
On 1 July the journal is reversed: debit Machine servicing, credit Prepaid expenses. The cover will be used in the new year, so its cost moves back into the expense account.
Common mistakes
- Accruing the whole bill. Only the months up to the year end belong to this year.
- Writing the journal the wrong way round. An accrual credits a liability. A prepayment debits an asset.
- Using Bank in the journal. Nothing has been paid or received on the day of the adjustment.
- Counting the months wrongly. A payment made on 1 February covers February, so there are five months to 30 June, not four.
- Leaving a prepayment in the expense account. Next year's cost stays in this year, so costs are too high and profit is too low.
- Forgetting to reverse. The whole bill then sits in the new year's expense, including the months already charged last year.
How to check your work
- Each expense for the year covers twelve months, no more and no less.
- The months in this year plus the months in next year add up to the months the bill covers.
- Each journal has equal debits and credits, and neither uses Bank.
- Accrued expenses is under current liabilities and prepaid expenses is under current assets in the statement of financial position.
In a year that has an opening adjustment as well as a closing one, both count.
- An opening accrual is taken off what was paid. A closing accrual is added.
- An opening prepayment is added to what was paid. A closing prepayment is taken off.
Practise it
Words used here
- Accrual
- An accrual is a cost a business has used by the year end but has not yet paid or been billed for.
- Prepayment
- A prepayment is a cost paid before the year end that will be used after it. It is carried forward as an asset.
- Journal
- The journal is the book of prime entry for anything that fits in neither a day book nor the cash book.
- Expense
- An expense is a cost of running a business in a period, such as rent, wages or electricity.
- Current asset
- A current asset is cash, or something that should turn into cash within a year: inventory, trade receivables, money in the bank.
- Liability
- A liability is money a business owes to someone else, such as a bank loan or an unpaid supplier bill.
Questions
Is an accrual an asset or a liability?
A liability. The business has used the cost and owes the money, so accrued expenses are shown under current liabilities.
Is a prepayment an asset or a liability?
An asset. The business has paid for something it has not used yet, so prepaid expenses are shown under current assets.
What is the journal for an accrual?
Debit the expense account and credit Accrued expenses. The cost for the year goes up, and a liability records what is owed.
What is the journal for a prepayment?
Debit Prepaid expenses and credit the expense account. The cost for the year goes down, and an asset carries the unused part forward.
Why are accruals and prepayments reversed in the new year?
When the bill is paid it is debited to the expense in full. The reversal cancels the part that was already charged last year, so no month is counted twice.