For any accounting role, accruals and prepayments are something you will need to be familiar with, so that you can ensure finances are recognised in the correct accounting period.
So, what are accruals and prepayments, and how do you use them to make appropriate adjustments?
Prepayments are payments that are made in advance of the relevant accounting period.
To understand prepayments, let’s work through an example.
- The year end is June 20-3
- Opening balance in July 20-2 is prepayment £450
- Rent received for the year is £5,850
- This includes £1350 that covers June, July and August
Rent received is a revenue account. When a revenue account is increased it is credited. When a revenue account is decreased it is debited.
The £450 was a prepayment from last year, so this means we had received income last year that needs to be in this year. For last year, we have debited rent received (to reduce the balance), and credited prepayments.
This year we need to reverse that journal and put the income in the correct year. So, we need to increase rent received (credit) and decrease the prepayment (debit). The account should now look like this:
|Statement of P&L||£5400||Op bal||£450|
This is the reasoning we follow to get to that point:
- The bank shows rent received of £5,850. This has increased the amount received so we credit the account.
- However, included in this figure is £1350 that takes us to the end of August. We are only taking into account figures to the end of June, so we have 2 months too much. To remove the extra amount, we will reduce rent received by £1350/3 x 2 = £900. To reduce the account we need to debit the rent received.
- The balancing figure of £5400 needs to debit the account and credit the statement of profit and loss. Remember, it is income, therefore increasing the profit, and therefore a credit.
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An accrual is an amount that is still due by the end of an accounting period. To understand accruals, we can work through the following example.
- The year end is June 20-3, and the opening balance on the vehicle expense account is an accrual for £220.
- £6,450 has been paid for vehicle expenses this year.
- £380 is required in June 20-3, but is paid for in July 20-3.
Vehicle expenses are an expense account. When an expense account is increased it is debited. When an expense account is decreased it is credited.
Last year, the opening accrual of £220 needed to be included in the vehicle expenses account. So, to increase the vehicle expenses account it was debited, and accruals was credited. We now need to reverse this journal. The amount of £220 will be going into the vehicle expenses account from the bank this year. We need to take it out as it is not required.
As the amount of £220 will be going into the vehicle expenses account from the bank this year, we need to take it out as it is not required.
This is what the account will look like:
|Statement of P&L||£6450||Op bal||£220|
These are the steps we need to take to get this result:
- To reduce the vehicle expenses account, we need to credit it with £220. We will debit accruals with £220.
- This year, bank payments of £6450 have been paid. This will increase vehicle expenses, so we need to debit the account.
- An amount of £380 was paid in July, but is required in June. So we need to increase the vehicle expense account by £380. This means we must debit vehicle expenses and credit accruals.
- The balancing figure of £6610 needs to credit vehicle expenses. As it is an expense, it is reducing the profit. Therefore, it will need to debit the statement of profit and loss.
Prepayments and accruals are covered in more depth on the AAT Level 3 Advanced Diploma, within the Accounts Preparation unit.
The examples above are taken from the Osborne Books Accounts Preparation Tutorial.