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Accruals & Prepayments for Dummies!

This free online course will teach you the basics of prepayments and accruals. Scroll down to get started

The Course Covers:
 

  • The Basics of Prepayments

  • The Basics of Accruals

  • Prepayment Examples

  • Accruals Examples

  • Double Entry Explanations 

  • Trial Balance Adjustments

  • And more

 

Course Modules:

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Prepayments and Accruals Explained!

Prepayments & Accruals Basics

Part 1: An Introduction to Prepayments

Module overview:

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  • Course Introduction 

  • What are Prepayments? 

  • Prepayments Basics 

  • And more

What are prepayments?

Prepayments account for expenses billed within a reporting period but incurred afterwards. In other words, a prepayment moves an expense from the reporting period to a future period. 

Why are prepayments needed?

Financial reports must only show sales and expenses relevant to the reporting period. If they are irrelevant they need to be moved to the period(s) in which the sale or expense was incurred. Without prepayments, financial reports could be misleading. 

Prepayment example

An example of a prepayment is insurance paid annually: 

 

An insurance bill covers twelve months of insurance at £/$/€ 50 a month

The total invoice is for £/$/€ 600

The invoice is dated March 20XX

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Without a prepayment, the March 20XX profit and loss statement will show £/$/€ 600 of insurance costs, and the rest of the financial year reports may show none. 

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A prepayment will adjust for this, so £/$/€ 50 shows as an expense each month of the financial year. The cost is spread as it is incurred. 

Common prepayments

Common prepayments include:

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Insurance (if paid annually)

Software (if paid annually)

Subscriptions (if paid annually)

And any other costs paid upfront

Prepayments Example

Part 2: Prepayment Examples

Module overview:

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  • How to do a prepayment

  • Prepayment debits and credits 

  • Prepayment examples

  • And more

Prepayment Example #1

The financial year-end is 31 March 202X. In January 202X, an insurance payment of 1,200 covered the period from 1 January 202X to 31 December 202X. A prepayment is needed to separate the insurance expense between two financial years. 

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The first step is to identify the periods covered by the expense. In this example:

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Three months within the financial year 31 March 202X (January, February, March)

Nine months within the next financial year (April, May, June, July, August, September, October, November, December)

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So, a prepayment is needed to move nine months of insurance expenses from the reporting period to the next reporting period. 

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The next step is to calculate the value of the prepayment. Here is the formula:

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(Full cost of expense/entire period of expense)*prepayment period

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In this example, the calculation will be:

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(1,200/12)*9 = 900. The prepayment is 900.

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The third step is to journal the prepayment dated at the end of the reporting period. Prepayments are an asset, so they are a debit entry (balance sheet). One of the purposes of a prepayment is to reduce the expenses in the reporting period, so credit expenses (profit and loss). The journal for this example will be:

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Debit prepayment asset 900

Credit insurance expense 900

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This is the double entry. 

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The final step is to reverse the journal in the next reporting period. This will clear the prepayment and show the profit and loss expense in the next reporting period. In this example, the reversal will be: 

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Debit insurance expense 900

Credit prepayment asset 900

Prepayment Example #2

The financial year-end is 31 December 202X. In June 202X, there was an annual software payment of 720 covering the period from 1 June 202X to 31 May 202Y. A prepayment is needed to separate the software expense between two financial years. 

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Step One

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Seven months within the financial year 31 December 202X (June, July, August, September, October, November, December)

Five months within the next financial year (January, February, March, April, May)

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Step Two

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(720/12)*5 = 300. The prepayment is 300.

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Step Three

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Journal dated 31 December 202X

Debit prepayment asset 300

Credit software expense 300

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Step Four

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Journal reversal dated 01 January 202Y

Debit software expense 300

Credit prepayment asset 300

Accruals Explained

Part 3: An Introduction to Accruals 

Module overview:

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  • What is an accrual? 

  • Accrual basics 

  • Accrual calculation 

  • And more

What are accruals? 

Accruals are used to account for expenses billed in arrears. In other words, an accrual moves an expense dated after the reporting to the reporting period.  It is the opposite of a prepayment. 

Why are accruals needed?

Financial reports must only show sales and expenses relevant to the reporting period. If expenses relevant to the period are not showing because they are billed after the period, they need to be moved to the period. Without accruals, financial reports could be misleading. 

Accrual example

An example of an accrual is accounting fees paid annually. Accounting fees are usually billed for a quarter or year after the period has ended.

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Here is an example: 

 

The accounting invoice covers services for the year 30 June 202X. It is dated 15 September 202X

The total invoice is for £/$/€ 950

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Without an accrual, the 30 June 202X profit and loss statement will not show £/$/€ 950 of accounting costs relevant to the period.  

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An accrual will adjust for this, so £/$/€ 950 shows as an expense in the relevant period. 

Common accruals

Common accruals include:

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Accounting costs 

Loan interest

Wages, salaries and subcontractor costs

And any other expenses billed in arrears 

Accruals Examples

Part 4: Accruals Examples

Module overview:

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  • How to do an accrual 

  • Accruals double entry 

  • Accruals examples 

  • Prepayments and accruals in the trial balance

Accruals Example #1

The financial year-end is 30 June 202X. In September 202X, an invoice was received for accounting costs covering the period from 1 March 202X to 30 June 202X. The invoice is dated within the next financial year and has a value of 600, so an accrual is needed to bring the expense into the financial year, 30 June 202X.

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The first step is to identify the periods covered by the expense. In this example, all four months of service are within the financial year 30 June 202X (March, April, May, June). 

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The next step is to calculate the value of the accrual. Here is the formula:

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(Full cost of expense/entire period of expense)*accrual period

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In this example, the calculation will be:

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(600/4)*4 = 600. The accrual is the full 600. 

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The third step is to journal the accrual dated at the end of the reporting period. Accruals are a liability, so they are a credit entry (balance sheet). One of the purposes of an accrual is to increase the expense in the reporting period, so debit expenses (profit and loss). The journal for this example will be:

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Debit accounting expense 600

Credit accruals liability 600 

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This is the double entry. 

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The final step is to reverse the journal in the next reporting period. This will clear the accrual and reduce the expense in the next reporting period's profit and loss. In this example, the reversal will be: 

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Debit accruals liability 600 

Credit accounting expense 600 

Accruals Example #2

The financial year-end is 31 January 202X. In March 202X, a subcontractor invoiced the business 1,500 for services covering January and February. An accrual is needed to separate the subcontractor cost between two financial years. 

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Step One

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One month is within the financial year 31 January 202X (January) 

One month is within the next financial year (February)

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Step Two

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(1500/2)*1 = 750. The accrual is 750. 

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Step Three

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Journal dated 31 January 202X

Debit subcontractor cost 750 

Credit accruals liability 750 

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Step Four

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Journal reversal dated 01 February 202X

Debit accruals liability 750 

Credit subcontractors cost 750 

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