Accruals and Prepayments

You have learnt under the accruals concept that costs and revenues must be matched together in the period incurred. This gives rise to a sale when goods and services are delivered on credit, with the other side of the double entry being to debit the debtors account.

Accruals and prepayments are like creditors and debtors, except that there is no invoice awaiting payment. In a sense, we step back and ask ourselves what services have we been using for which no invoice has been received, and what expenses have we paid for which haven’t been used up at the period end.

Common examples of prepayments are rent, rates, insurance and road tax paid for in advance, where there is still some time remaining after the accounting period end date. Common examples of accruals are electricity, gas and telephone which are paid in arrears where the last payment was made before the period end date and we haven’t yet reached the next payment date.

Accounting for Accruals

Suppose that electric bills for powering the factory for 3 quarters and totalling £1,800 have been received and entered in the general ledger. It is now the end of the financial year, the last bill received was for a quarter that ended a month ago, and the next bill won’t be due for at least two months. A simple pro-rata approach tells us that we have incurred one month’s worth of electric charge valued at £200. This amount must be added to the debit side of the electricity account as an actual expense. The other side of the double entry, is to credit the accruals account – a creditor.

This accrual balance will appear in the balance sheet under current liabilities, but will not remain there. It is immediately transferred back to the electricity account as an opening balance on the credit side. Here’s what it looks like.

Accrual_1 1

On the debit side we have entered the £1,800 for the bills already paid. We then make another debit of £200 for the accrued expense, and post it as “Balance c/d” (any balance c/d figure must be brought down later to the other side of the account). The other side of the double entry is to credit the accruals account by £200 (not shown because it is soon cleared out - see later).

Accrual increases expense by £200
Notice the entry for £2,000 on the credit side. This simply shows the amount being transferred to the profit and loss account - an expense in this case. The step of writing out a profit and loss account as a “T” account like this is normally omitted and the data is simply transferred to the final format as it will appear in the financial statements.

Clearing Accruals account
The other side – the credit entry in the accruals account – is cleared out as soon as the balance sheet has been written. We would do this by debiting the accruals account and crediting the electricity account. This is done in a single step by bringing the balance of £200 to the credit side of the electricity account, where it forms the opening balance for the new period. So we never need to actually set up a "T" account for accruals - we just need to add up all the "Balance c/d" values to get the total accruals.

Next periods expense is reduced by £200
Finally, notice that having an opening balance on the credit side, has the effect of reducing the amount of expense charged to the profit and loss account next year by £200. This should be intuitive, because that £200 was part of the year just finished, and has nothing to do with the following year’s expenses. It just means that when we receive the bill for £600, the expense is offset by £200.

Accounting for Prepayments

Prepayments are the reverse of accruals in which we have paid for services not consumed by the period end. Suppose we have paid £1,200 for premise insurance that runs from a period midway in the financial year, and expires after 12 months. We have effectively paid for 12 months but only used up 6 months, and therefore have a prepayment of £600.

Prepayment_2 1

We have debited the Insurance account for the £1,200 actually billed. But because only half relates to the period just ended, the expense charged to the profit and loss account must be £600, not £1,200. We therefore enter the prepayment as £600 as the "Balance c/d" figure on the credit side. This reduces the profit and loss item to £600.

Debit the Prepayment
The other side of the double entry is to debit prepayments by £600 which appears in the balance sheet under current assets. We then clear the prepayments account by crediting it by £600 and debiting the insurance account. This is done in a single step by simply bringing down the balance to be the opening balance on the debit side of the insurance account.

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