Accruals and prepayments – Level 3 study tips

The accruals (also known as matching) concept of accounts states that the figures shown on the final accounts of a business must accurately represent the financial period they are from. 

So the statement of profit or loss must show the income and expenses which were incurred in a period, not necessarily the same as the receipt (income) or payment (expense) made from the business bank accounts in that period. 

This makes sense if considered logically. Let’s say that 3 years rent is paid up front for a property. Does this mean there’s no rent incurred in years 2 and 3? The answer is no, we still incur the expense it just means we have already paid for it. 

By making adjustments for accruals and prepayments we ensure that the profit/loss figure is representative of the time period in question.

What are accruals and prepayments?

• Accrual: A balance for an expense or income that will be paid/received in the current financial period but was actually incurred in the previous period
• Prepayment: A payment for an expense or income that was paid/received in a previous financial period but relates to an expense/income incurred in the current financial period

What do the general ledger accounts look like?

The following are a series of scenarios looking accruals and prepayments for both an expense and income account. In order to make the figures as simple to follow as possible, there are a few assumptions made:

• Electricity expense is a flat rate of £1,000 per month and will therefore always be £12,000 on the statement of profit or loss for the full year
• Rental income is a flat rate of £1,200 per month and will therefore always be £14,400 on the statement of profit or loss
• Bank payments will be made on 31^st December (the end of the financial year)
• There are no opening accruals/prepayments in the current financial year.

Scenario one – Accrued balances for Electricity expense and Rental income

The first case study has the following information:

• £10,000 is paid for electricity at the end of 20X5, the remaining balance for the year is not billed until January 20X6 and therefore not paid yet. An accrual of £2,000 therefore exists at the end of the year representing an unpaid expense incurred in the year. An adjustment for this outstanding debt must be made in the ledger account and therefore displayed accurately on the financial statements

• £7,200 is received from the occupant of the rental property at the end of the financial year. It has been agreed that the other £7,200 will be paid in the following February. The occupant has lived in the property all year and therefore the £7,200 accrual will need to be taken into account when producing the financial statements

The ledger accounts

The final accounts

• The electricity expense shown on the statement of P/L will be £12,000 (despite only £10,000 being paid from the bank account)
• The rent received figure shown on the statement of P/L will be £14,400 (despite only £7,200 being received at the end of the year)
• The £2,000 accrual from the electricity account will be shown as a current liability on the statement of financial position because it is a debt which the business owes at the end of the year
• The £7,200 accrual from the rent received account will be shown as a current asset on the statement of financial position because it is a revenue which the occupant of the property owes us at the end of the year, it is therefore an asset just like any other receivable

Scenario two – Prepaid balances for Electricity expense and Rental income

The second case study has the following information:

• At the end of the year, the business pays £15,000 from the bank account, only £12,000 of this is for the current period, the rest is an advance payment for the following year. An adjustment for this advanced payment must be made in the ledger account and therefore displayed accurately on the financial statements
• The occupant of the rental property has paid £18,000 rent at the end of the year. This payment includes a prepayment for the first 3 months of the following year. The account must be adjusted in the general ledger to accurately represent 20X5 on the statement of P/L

The ledger accounts

The final accounts

• The electricity expense shown on the statement of P/L will be £12,000 (despite £15,000 being paid from the bank account)
• The rent received figure shown on the statement of P/L will be £14,400 (despite £18,000 being received at the end of the year)
• The £3,000 prepayment from the electricity account will be shown as a current asset on the statement of financial position because it is a payment we have already made and therefore treat in a similar manner to a positive bank balance
• The £3,600 prepayment from the rent received account will be shown as a current liability on the statement of financial position because it is a revenue which the occupant of the property has already paid us, it is therefore a liability because we technically ‘owe’ the occupant this payment at the start of 20X6

In summary

This article has hopefully illustrated the importance of accruals and prepayments as adjustments in the general ledger. Both scenarios have resulted in the same figures on the statements P/L for electricity and rent received regardless of the actual bank payments/receipts in the period.

The skills in this article transfer to AAT assessments and also just as importantly the workplace.

The following table may help summarise the key aspects of accruals and prepayments in the general ledger and the financial statements.

Read more on Advanced Diploma in Accounting with AAT:

• Tricky Topics Deciphered: Suspense accounts
• Study tips: Fixed overheads #1 – budgeted overheads and overheads recovery
• Study tips: Accounting principles and why you should understand them

Mathew Pickering is an AAT lecturer at The Sheffield College, part of the team which won Training Provider of the year (medium size provider) in 2015.