Accruals and prepayments with examples you can copy

The situation

It is the last working day of December and Yousef, the chief accountant at Crescent Holding, is walking Farida through the Palm Gate Logistics close. The warehouse used electricity all month, but the utility invoice will not arrive until January. Palm Gate also paid its annual insurance premium in October. Farida asks why December must show a cost for electricity nobody has billed, and why only part of the insurance payment is a cost.

The answer is the idea behind accruals and prepayments: costs belong to the period that used them, not the period in which the cash moved.

The explanation

Accounting records the effect of an event when it happens, not when the money moves. Two common cases show the gap between the two.

An accrual is a cost you have incurred but not yet been billed for or paid. The service has been used, so the cost belongs to this period. You record the expense now and a liability for the amount owed, usually called accrued expenses. When the invoice arrives, you clear the accrual instead of recording the cost a second time.

A prepayment is the reverse. You paid cash before you received the benefit. At the moment of payment you hold something of value for the future, so it is recorded as an asset, called prepaid expenses. Each month, the part you have used moves from the asset into expense.

The Conceptual Framework of the IFRS Foundation defines the elements of financial statements, including assets, liabilities and expenses. An accrual is a liability and a prepayment is an asset, and both exist because the books follow the activity, not the bank.

The same logic works for income. Income earned but not yet invoiced is accrued income (an asset). Cash received before you deliver is deferred income (a liability). These are covered in the next lesson.

To book either one correctly, ask four questions:

What did we use or receive, and over which period?
How much of it belongs to this period?
Has it been billed or paid already?
What will clear the balance later: an invoice, or the passing of time?

Estimates are normal. If the electricity bill is unknown, you estimate from the meter reading or last month. When the invoice arrives, you compare it with the estimate and book the small difference in the period the invoice arrives, unless it is large.

Worked example

Both cases are Palm Gate, in AED, and are small illustrations outside the September pack.

Accrual. Palm Gate used electricity in December. The invoice, expected in January, is estimated at AED 6,000. At 31 December: debit electricity expense 6,000 and credit accrued expenses 6,000. In January, when the invoice arrives for exactly 6,000, debit accrued expenses and credit the payable. No second expense is recorded.

Prepayment. On 1 October Palm Gate pays AED 12,000 for twelve months of insurance. At payment: debit prepaid insurance 12,000 and credit bank 12,000. Each month one twelfth, AED 1,000, becomes an expense. At 31 December three months have been used: expense 3,000, and the prepayment left on the balance sheet is 9,000.

December therefore carries 9,000 of cost for these two items: the 6,000 accrual plus 3,000 of insurance. If you had followed the cash, December would show no electricity cost and the whole 12,000 of insurance would have hit October, and every month's profit would have been wrong.

At 31 December the balance sheet shows accrued expenses of 6,000 as a liability and prepaid insurance of 9,000 as an asset.

The common mistake

The most common mistake is to record a cost only when the supplier's invoice arrives. It makes expenses appear in the wrong month and gives a flattering profit in the month before the invoice. The fix is a month-end review of goods and services received and not billed, using purchase orders, receipts and contracts.

The second mistake is to treat a payment in advance as an expense on day one. A twelve-month policy paid in October is not an October cost. Spread it over the months of cover.

The third mistake is to forget to reverse or clear the accrual when the invoice arrives, which counts the cost twice. Keep a schedule of accruals and prepayments, and tick each one off when it clears.

Checklist

I list goods and services received but not billed at every month end.
Each accrual has an estimate, a basis for it and an owner.
Each prepayment has a start date, an end date and a monthly amount.
I clear accruals when the invoice arrives, so the cost is counted once.
I review the schedule against the ledger balances every month.
Differences between estimate and invoice are booked in the right period.

Go further

Watch the full episode ACC-E10 Accruals and practise with the exercise in the lesson ACC-E10 Accruals.

Companies and figures in this article are fictional. Masar-Fintech is independent and not affiliated with any professional body or tax authority.