Why do we need Accruals and Prepayments?

Accruals and Prepayments is a difficult concept to grasp for many students. I remember the first time my tutor spoke to me about them, I thought he was speaking in an alien language. They are definitely something that takes time and effort to understand but I think if you get the concept of what is actually going on, it can help you to realise what you are doing.

Why do we need Accruals and Prepayments?

Accruals and Prepayments is a difficult concept to grasp for many students. I remember the first time my tutor spoke to me about them, I thought he was speaking in an alien language. They are definitely something that takes time and effort to understand but I think if you get the concept of what is actually going on, it can help you to realise what you are doing.

I am going to concentrate here on the expense accounts and ignore income. Once you understand what happens in the expense accounts, you can then move onto the income accounts where the entries will be on the opposite side. But for now, I want to work on the expense side of things.

What is an Expense

If you think of DEAD CLIC, the debit accounts are represented by “DEAD”.  The credit accounts are represented by “CLIC”
“E” is for Expense so this is a debit account.

The expenses are recorded in this account when we pay the money out of the business bank account. We will Credit the bank (money going out) and Debit the expense (to record the expense)

Simple right….. every time we pay an expense out of the bank we record the expense

Why do we need Accruals and Prepayments?

We need them because there is one other thing to know about expense accounts. We only want to show exactly 12 months expense before transferring that expense to the profit and loss account. So, if our yearly accounts are January to December, the only expense we need to record is the expense that relates to January to December.

The bank payments will come in during the year and we will record these in the expense accounts, but the bank payments may include payments for expenses outside of our 12 months accounting period.

We may pay a bill in February that relates to Nov/Dec/Jan…… Now Jan is OK as we want to include this in our accounts for this year.  However, November and December are for the previous accounting period, so we don’t want to include these, but we still must record the full bank payment.

We may pay a bill in Nov that relates to Dec/Jan/Feb……  December is OK as we want to include this in our accounts for this year. However, January and February are for the next accounting period, so we don’t want to include these, but we still must record the full bank payment.

The bank payments throughout the year may only relate to 10 months of our accounting period but we need to record to record the full 12 months.

Accruals and prepayments adjust the expense account around the bank payments so that exactly 12 months expense is recorded.

If we record 14 months of expense during the year, prepayments will adjust this to 12 months.  This will be done by removing 2 of the months with a prepayment

If we only record 10 months of expense during the year, accruals will adjust this to 12 months.  We will do this by adding 2 months to the expense account.

Prepayments

So, if one of the bank payments is at the end of the year and includes a payment for two months of the following year, we need to adjust the expense account by placing those two months into a prepayment account.

We do this by Crediting the expense account and Debiting the prepayment account.

The full bank payment is recorded on the Debit side of the expense account. Then the 2 months prepayment is entered on the Credit side of the expense account to reduce the expense.

Then the following year we will record the 2 months prepayment straight away in the expense account. We do this by Debiting the Expense account and Crediting the Prepayment account.

Can you see what we have done here? We have recorded the full bank payment in the expense account, taken the 2 months that we don’t want and placed them in the prepayment account, then the following year we have taken those 2 months out of the prepayment account and placed them in the expense account.

I think of the prepayment account as a kind of holding account for the months that I don’t need in this accounting period…… it holds them until the next accounting period starts and then places them in the expense account in the correct accounting period.

Accruals

If we record 10 months in this year’s expense account; we are 2 months short of the full 12 months needed. So, we need to add 2 months to the expense account.

We do this through the Accrual account.Then we receive a bill next year and part of that bill will include the 2 months of this year. We can only record that expense next year when we pay it. But 2 months belong to this year.

We need to take the value of those 2 months and place them in the expense account.  The other side of this transaction is recorded in the accrual account.

We do this by Debiting the expense account and Crediting the Accrual account.

So, the accrual is recorded on the debit side of the expense account, just like the bank payments.

Then the following year we empty the accrual account by doing the opposite. We Debit the accrual account and Credit the expense account. So, the expense account now has 2 months entered on the Credit side. What this now does is when the bill is paid (which includes 2 months of the previous year). It is recorded on the debit side of the expense account, the 2 months accrual on the credit side offsets the full bank payment as 2 months was already recorded in the previous accounting period.

Can you see what we have done here? We have generated an accrual of 2 months and recorded it on the debit side of the expense account, so we are recording 2 months expense ahead of the bank payment. Then the following year we record this on the Credit side of the expense account to reduce the full bank payment by the 2 months we have already recorded.

I think of the Accrual account as an advanced holding account…. We record the months in advance of the bank payment.  Then the following year it will reduce the full bank payment by the months we have already recorded.

We have another blog on accruals here which you might find useful

We also have a webinar on this subject here.

 

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