Defining Accruals and Prepayments - dummies

By Jane E. Kelly

Most people shudder at the thought of trying to define accruals and prepayments, let alone know how to process them. In reality, accruals and prepayments are relatively simple concepts that form part of the adjustments that you make at a period end (whether that be the month end or year end).

What is an accrual?

You accrue a cost where the goods or services have been received by the business but the business has not yet received the invoice. Recording costs with the related revenue for the month is good practice.

An example of accruing costs would be your telephone bill. Say you receive a telephone bill in April 201X for the period January to March 201X. Normally, you would process an invoice in the month that you received it, in this case April 201X. The problem with this, is that the telephone bill that you’ve received does not relate to goods or services received in April; the business actually benefitted from the use of the telephone service in the first quarter of the year (that is, January to March 201X).

To ensure that you are accurately matching costs when the services are actually received, you need to estimate the cost of the telephone bill for the quarter ahead and make an accrual in the accounts. For example, you assume that based on previous usage, your next telephone bill is likely to be £300. You then spread the £300 cost against the three months to which the bill relates. In other words, the telephone cost per month for January to March 201X should be £100 per month (that is, £300 / 3 months).

If your computer system does not automatically deal with accruals, then you need to create a journal as follows:

The double entry would be:

Debit Telephone costs £100
Credit Accrual £100
You would create this journal in January, February and March if
you’re doing monthly accounts.

When you receive the actual invoice, code it to accruals, not telephone (otherwise you’ll be double counting telephone costs).

By coding the invoice to accruals the following double entry will take place:

Debit Accruals £300
Credit Creditors Control Account £300
What are prepayments?

Prepayments are the opposite of accruals, where the business pays up front for a service that they haven’t actually received yet.

An example of a prepayment would be an invoice for building insurance. You receive the insurance bill 1 January 201X but the period to which the invoice relates to is the whole year ahead (that is, 1 January to 31 December 201X). If the business posts the whole invoice value into January the business’s costs for that month will be hugely overstated and the profit dramatically reduced. Spread the cost of the insurance instead throughout the whole year. For example, if the insurance is £12,000 for the year, then the cost per month should be £1,000 (£12,000 / 12 months).

Post the value of the original invoice to the prepayments accounts. The double entry that will take place automatically is:

Dr Prepayments £12,000
Cr Creditors Control Account £12,000
At the end of each month, as part of the adjustments, the
following journal would be done:
Dr Insurance £1000
Cr Prepayments £1000
Since the business may have more than one prepayment each
month, there may well be a prepayment schedule that the bookkeeper
may need to keep up to date and ensure that it agrees with the