What is an accrual or a prepayment?

Belong

Belonging

Your accounts will be prepared under what is known as the “accruals basis” – unless you are self-employed and choosing to do cash accounting. Accruals basis sounds a bit technical but it isn’t that bad really. I think about it in terms of “belonging”. You can only include sales and expenses that “belong” in or relate to the current financial year. Your accounts are not based on the money that was actually paid or received in the year, they are based on what should have been paid or received i.e. what belongs there.

We’ll just look at the expenses side for now with Accruals and Prepayments. You might get one or both of these in your accounts.

Prepayments

These are when you have paid a bill in this financial year that belongs, or partly belongs in the next one.

Example: A good example of a prepayment is rent. Your year end is 30 April and on 5th April you pay three month’s rent in advance to your landlord covering April, May and June. We would have to split the bill into two parts, one month’s worth for April that belongs in the current financial year and two month’s worth for May and June that belong in the next financial year.

The April part would end up in your profit and loss account because it is an expense that belongs to the current year.

The May and June parts would end up on your balance sheet as a prepayment because they belong in the next financial year. Prepayments are a type of debtor. Debtors are people or organisations that owe you money. At the end of April the landlord effectively owes you two month’s worth of rent because you have paid for rent that you have not yet used.

Accruals

These are when an expense for this financial year does not get paid until the next financial year.

Example: The best example of this is for a phone bill or utility bill. Your year end is 30th April and on 5th June a direct debit comes out of your bank account for your electricity bill covering March, April and May. We could need to split the bill into two parts, two months worth for March and April that belong in this financial year and one month’s worth for May that belongs in the next financial year.

The May part would end up in the profit and loss account for the next year.

The March and April parts would end up in the profit and loss account for this year because the expense belongs to the current year. However, at the year end the bill had not been paid and the expense had not yet come out of the bank account. If we show it as having been paid at 30th April the bank balance would not be right. So instead we have to put in an accrual on the balance sheet.

An accrual is a type of creditor; people or organisations that you owe money to. An accrual represents spending on credit. At the end of April you have used electricity for March and April so that expenditure belongs in the profit and loss accounts but at that point you still owe the electricity company the money for it, so we make an accrual to represent the money that you owe.

Another example of an accrual is for accounting fees. We prepare your accounts and invoice you for the work after your financial year end date, but the cost of this accounting work also belongs in the year’s accounts. Unless you are spreading your payments monthly, we always make an accrual cover the accounting fees. Even though at the year end the work had not been done or invoiced, the accrual provides the best estimate of how much it will cost so that the relevant costs are included in the right year.

Image: Belong – Duncan Rawlinson