Accruals and prepayments

Accruals and prepayments – the bane of an AAT student’s Level 3 life!.

In this post, I’m going to try and explain accruals and prepayments in a way that will (hopefully) help you to understand them.

Before we even try to tackle a prepayment or accrual, it’s important to remind ourselves about the effect of a transaction on a t-account:

Prepayment of expenses

Imagine you have a 13 litre bucket full of water (Bucket 0X1) and an empty 13 litre bucket (Bucket 20X2) (stay with me here).

20X1		20X2

  

You move 1 litre water from bucket 20X1 to Bucket 20X2. You now have one bucket with 12 litres in (20X1) and one with 1 litre (20X2).

20X1		20X2

Now, instead of buckets and water, we have expense accounts and amounts – can you see where I’m going with this? The water represents monetary amounts – the buckets represent accounts. Here, we’re saying that £1 is being moved from 20X1 to 20X2 as it ‘belongs there’ as the expense relates to an expense that will be incurred during 20X2 (e.g. advance payment of rent). We’ll take £1 from 20X1 and move it to 20X2 by using double entry bookkeeping so that we correctly show the amount of expenditure that applies to 20X1 and the £1 is already registering as a prepaid expense (albeit prepaid) in 20X2. The balancing figure for this t-account of £12 is the expense for the year.

Expense Account
31/12/20X1	Bank	13	31/12/20X1	Prepayment c/d	1
			31/12/20X1	Statement of profit or loss (SPL)	12
		13			13

The prepayment is held in a prepayment account until the start of the new year when we transfer it to the expense account for 20X2:

Prepayment
31/12/20X1	Prepaid expense b/d	1	1/1/20X2	Expense	1
		1			1

Expense Account
1/1/20X2	Prepayment	1

This £1 will be included in 20X2’s expenses plus any further expense incurred during the year.

Let’s now look at accrued expenses (accruals)

Again, we use the bucket analogy:

		1 litre belongs in 20X1
20X1		20X2

Here we’ll top up 20X1’s bucket with the yellow 1 litre:

20X1		20X2

Now we can see that 20X1 is full and that 20X2 has reduced in volume by 1 litre.

Again, we can take this analogy and turn it into an accounting question:

Expense Account
31/12/20X1	Bank	12	31/12/20X1	SPL	13
31/12/20X1	Accrued expense c/d	1
		13			13

As with prepayments, the accrual is reversed at the start of the new year:

Accrued expense
1/1/20X2	Expense	1	1/1/20X2	Accrued expense b/d	1
		1			1

Expense Account
			1/1/20X2	Accrued expense	1

It’s common to have to deal with accruals as you will receive invoices relating to events, purchases and services used after the year end. You will allocate part of the invoice to the previous year (20X1) with the remainder relating to the current year 20X2.

Prepaid and accrued Income can be dealt with in a very similar manner – making sure that you remember that incomes naturally exist on the credit side of the t-account so, to increase the value of the t-account (an accrued expense) you credit it and debit the accrued income and to decrease the income account (prepaid income) you debit the income account and credit the prepaid income account.

IMPORTANT

You need to understand that the accruals and prepayments are carried between years (as we saw above) via the statement of financial position (or as old people call it – the balance sheet).

Prepaid expenses	Debit	Current asset (as we’re owed the money as we paid upfront and so could ask for a refund)
Accrued expenses	Credit	Current liability (a s we owe the amount at year end – we’re liable to pay it)
Prepaid income	Credit	Current liability (we could be asked to repay the customer if we fail to deliver)
Accrued income	Debit	Current asset

In my experience, the thing people have most difficulty with is deciding what part of the expense/income relates to the year we’re dealing with and what part relates to next year/last year. Obviously, we’re likely to encounter situations when the expense or income relates to parts of two accounting periods.

The best way to deal with these is to use a timeline approach.

Example

You have been working on a business’ accounts for the year ended 31 December 2013. You may ignore VAT for this task.

You have the following information:

Balances at:	1 January 2013
Accrual for rent paid	£800
Prepayment for motor expenses	£600

The bank summary for the year shows payments for rent of £11,250. Included in this figure is £1,800 for the quarter ended 28 February 2014

a)      You are to write up the Rent paid account for the year ended 31 December 2013 and close it off by showing the transfer to the statement of profit or loss. (You do not need to show dates)

Rent paid
Bank	11,250	Accrual b/d	800
		SPL	9,250
		Prepayment c/d	1,200
	11,250		11,250

The bank summary for the year shows payments for motor expenses of £15,700. In January 2014, £250 was paid for administration expenses incurred in December 2013.

b)      You are to prepare the administration expenses account for the year ended December and close it off by showing the transfer to the income statement. Include dates.

Motor expenses
1/1/13	Prepayment b/d	600	31/12/13	SPL	16,550
31/12/13	Bank	15,700
31/12/13	Accrual   c/d	250
		16,550			16,550

So, let’s see how we can solve this question with a time line approach.

In part (a) we’re told that some of the expense we’ve paid during the year (£1,800) relates to the quarter ended 28^th February 2014. 

A ‘quarter’ is 3 months so, we can now assign a monthly figure for this expense (we assume that expenses/incomes occur evenly over time):

£1,800 ÷ 3 = £60 per month.

Our year end is 31 December 2013.

Now, let’s put all of this onto a timeline:

£1,800 for the period 1 December 2013 – 28 February 2014
£600	£600	£600
December 2013	January 2014	February 2014
Year end

Using this approach makes it much easier to see that only part of the £1,800 ‘belongs’ on 2013, with the remainder belonging in 2014.

We must also ensure that we’re very clear on when this expense was actually paid - here we’re told that it’s included in the expenses account at the end of 2013 and so it must be a prepayment. So, we have £1,200 prepaid and can now carry out the t-accounting: Debit Prepayment, Credit Expense

Part (b) – here we can adopt a similar procedure:

Belongs here	£250 (paid here)
December 2013	January 2014	February 2014
Year end

Again, the expense must be moved – but this time, backwards into 2013. As we’ve not yet paid it, it must be an accrual so we can now Debit Expense (2013) £250 and Credit Accrued expense £250.

It’s common to see a similar situation as with part (a) where an accrual relates to two financial years – adopting the timeline approach will help you tackle the question confidently.

In summary, then, we need a standard approach to any accrual/prepayment question so, why not try this:

1)      Establish the position at the start of the financial reporting period (i.e. the beginning of the year we’re dealing with)

2)      Identify the bank transactions for each income or expense.

3)      Establish the position at the end of the reporting period – do we have any prepayments or accruals of expenses of incomes.

4)      Balance off the t-account to calculate the expense/income figure for the reporting period you’re dealing with (The SPL figure).

Hopefully, these rambling will help you get to grips with accruals and prepayments – please leave a comment if you find any errors or would like to request a subject for a Level 3 blog post.

Good luck