How to record accruals and prepayments

Step by step

1. Identify the expense period. For each expense, work out how much relates to this accounting period.
2. Accrue unpaid amounts. If part of this period's expense is unpaid at the year end, add it to the expense. Show it as a current liability (an accrual).
3. Remove prepaid amounts. If you have paid in advance for next period, subtract it from the expense. Show it as a current asset (a prepayment).
4. Adjust the income statement. Charge the adjusted expense figure in the income statement.
5. Adjust the statement of financial position. Show accruals under current liabilities and prepayments under current assets.

Worked example

Rent paid is RM11,000, but RM1,000 relates to next year. Charge RM10,000 as the expense and show RM1,000 as a prepayment (current asset).

Understanding the method

Businesses pay bills early, late and in lumps, so the cash paid in a year rarely equals the expense that belongs to that year. Accounts follow the matching concept: an expense belongs to the period in which the benefit was used, not the period in which cash moved.

An accrual is a benefit used but not yet paid for. It is an amount owed at the year end, so it is a liability, and it increases the expense.

A prepayment is the reverse: paid for, but not yet used. It is an asset, and it reduces the expense.

Start by working out the expense that belongs to the year, then compare it with the cash paid. If the correct expense is higher than the cash paid, the difference is an accrual. If it is lower, the difference is a prepayment.

Example 1. Rent is RM1,000 a month.

Twelve months were used but only ten were paid. The income statement shows the full RM12,000, and RM2,000 is a current liability.

Example 2. Insurance of RM2,400 covers a year, but three months fall in the next period. RM600 is a prepayment (current asset), and only RM1,800 is this year's expense.

Example 3. Electricity paid in cash was RM3,600, and an unpaid bill of RM500 covers electricity already used.

The expense is 3,600 + 500 = RM4,100, and RM500 is an accrual. Business rates of RM4,800 include RM1,200 for next year, so the expense is 4,800 − 1,200 = RM3,600, and RM1,200 is a prepayment.

To check, rebuild the expense from the rate: months of benefit × monthly rate should equal the expense you charged. The amount added to or removed from the expense must equal the liability or asset you show.

Income works the same way with the signs reversed. Rent receivable that is owed to the business is accrued income (an asset). Rent received in advance is prepaid income (a liability).

Common mistakes: ignoring last year's opening accrual or prepayment (the opening accrual must be removed when paid, or the expense is charged twice). Another is counting the months paid instead of the months of benefit.

If you find it hard to tell whether an adjustment adds to or reduces an expense, we can help. One of our teachers can practise accruals and prepayments questions with you until the direction becomes automatic. Book a trial class

Related skills

• How to prepare an income statement for a sole trader
• How to prepare a statement of financial position

The methods here are standard accounting practice, with original figures. For your exam board's exact requirements, see exam boards and Sources.