‘Accounting is accrual profession.’
Anonymous
In a nutshell
| Prepayments (prepaid expenses) | Accruals (accrued expenses) |
|---|---|
| Goods or services which have been invoiced and paid, but not yet received. | Goods or services which have been received, but not yet invoiced or paid. |
Prepayments and accruals are both examples of the ‘matching’ concept (somewhat confusingly also known as the ‘accruals’ concept) (see Chapter 1 Business accounting). The objective is to match expenses to the period in which they are incurred, as opposed to paid.
One of the key things to be aware of is the dual impact of accruals on a business’s financial statements.
Need to know 
Essentially, prepayments and accruals can arise where there is a timing difference, overlapping a period end, between receiving a good or service and its associated invoice/payment. Examples of typical prepayments and accruals are provided below.
| Prepayments | Accruals |
|---|---|
|
|
Examples
ABC Ltd’s accounting year is based on calendar years, whereas its insurance bill (which it pays annually in advance) runs from 1 July to 30 June. At 31 December, there will be 6 months of prepaid insurance which is not yet ‘used’. Therefore, there will be a prepayment equal to half of the amount paid.
ABC Ltd pays its utility bills 3 months in arrears, at the end of January, April, July and October each year. At 31 December, the business will have 2 months of utility expenditure which will not be paid until 31 January, after its year end. It will, therefore, make an accrual for the 2 months of utilities received, not yet paid. This will be an estimate based on the previous quarter/year’s bill and current usage.
Impact on the financial statements
| Prepayments | Accruals | |
|---|---|---|
| P&L |
|
|
| Balance sheet |
|
|
| Cash flow |
|
|
Why is this important? 
Accruals are important as they impact on both the profit and loss (P&L) and balance sheet (see the table above).
The financial impact of accruals on profit is not always certain as accruals are often estimated. There should, however, be a sensible basis to their estimation. For example, a company which needs to estimate its electricity bill may look at meter usage compared to the previous quarterly bill, or simply use last year’s estimate as the basis for the accrual (if there has been no significant change in operating activity).
It is important to be aware that accruals must be based on expenditure which the business will be making for goods and services which it has already received.
When is this important? 
Businesses which prepare regular management accounts (see Chapter 31 Management accounts) may calculate accruals and prepayments on a monthly as well as an annual basis. The most important time, however, is at the financial year end as the final accrual will have an impact on year-end profit and the year-end tax calculation.
Accruals can affect levels of profit between different years. Take the example of a particularly prudent accrual for legal fees in year one, which is overestimated by £1,000. This will have the impact of reducing year one’s profit by £1,000 and increasing year two’s profit by £1,000. This is because the over accrual is adjusted the following year to reflect actual expenditure, once the actual invoice is received.
In practice 
| Prepayments | Accruals |
|---|---|
Some services such as insurance, licences and rent will require upfront payment as a matter of course. However, there are other times when it may be advantageous to prepay for goods or services. For example:
On the other hand, prepayments represent a cash outflow which has an associated finance cost. There is also the risk of becoming an unsecured creditor if the business in receipt of the prepayment becomes insolvent. | Accruals are effectively free credit for a business. For example, Contractor X takes one month to raise its invoice and Business Y pays its suppliers one month after receiving invoices. In this example Business Y has effectively received 2 months’ credit. For one month the debt will be classified as an accrual, and then once the invoice is raised the amount owed will be classified as a trade creditor. In practice, however, accruals result in more administration. The finance department will know the value of its trade creditors, as the accounting system will have a record of invoices received from suppliers (see Chapter 2 Finance personnel and systems). However, the finance department may not know about goods or services received which have not yet been invoiced. It will need to obtain information from operational staff at the period end to be aware of the full extent of its liabilities. Most well-controlled, established businesses will in practice have systems in place (for example, purchase orders) to identify where and when accruals are necessary. |
Nice to know 
The income perspective
So far, this chapter has considered expenditure, both deferred (prepayments) and accrued (accruals). We will now look at deferrals and accruals of income – see the following table.
| Deferred income | Accrued income |
|---|---|
Where a business receives prepayments (or deposits) from a third party this is treated as deferred income (or revenue). In other words, income has been received (in the form of cash) but not yet earned (as the goods have not yet been delivered or the service has not yet been performed). As the income is not yet earned, this is recognised as a short-term creditor on the business’s balance sheet. There is a liability to a third party. Deferred income is good for cash flow. | Where a business has provided goods or services to a third party but not yet sent an invoice, this is treated as accrued income (or accrued revenue). As income has been earned, but not yet invoiced (or received), it is recognised as a short-term debtor (asset) on the business’s balance sheet. Professional service firms such as lawyers, and businesses working on long-term contracts such as builders, often have challenges managing working capital due to large volumes of ‘unbilled work-in-progress’ or accrued income. In practice, businesses should aim to minimise accrued income, and turn it into debtors instead by invoicing promptly and giving the debtors a set time to pay. |
Summary
| Assets | Liabilities | |
|---|---|---|
Income | Accrued income Earned, not yet invoiced | Deferred income Received, not yet earned |
Expenditure | Prepayment Paid, not yet incurred | Accruals Incurred, not yet paid (or invoiced) |
Rule of thumb
An accrual often occurs before a receipt or payment. A deferral occurs after a receipt or payment.
Optional detail 
Accounting for prepayments and accruals
Accruals and prepayments are one of a number of period-end adjustments. Other typical adjustments include depreciation (see Chapter 9 Tangible fixed assets and depreciation), amortisation (see Chapter 10 Goodwill and other intangibles) and bad debt provisioning (see Chapter 12 Debtors and creditors). A manual journal entry is typically made by an accountant to adjust the balances in the accounting records (see Chapter 2 Finance personnel and systems).
Alternative terminology
| Prepayments | Accruals |
|---|---|
Prepaid expense Prepayments is simply a commonly used abbreviation for a prepaid expense. Deferred expense A prepayment is also known as a deferred expense. Although cash has left the business the associated good or service has been deferred to a future period. | Accrued expense Accruals is simply a commonly used abbreviation for an accrued expense. GRNYIs In some businesses, especially those involving physical goods such as retailers and manufacturers, accruals are often referred to as ‘GRNYIs’ (pronounced gurneys). This is just an acronym for ‘Goods Received Not Yet Invoiced’. Sometimes this acronym is further abbreviated to GRNI. |
Reflect and embed your understanding 
- 1Why do accountants and auditors spend significant time working on accruals?
- 2Should a business be prudent when estimating an accrual? What is the impact of being under or over prudent?
- 3Why can deferred income be positive despite being recognised as a liability?
- 4Why can accrued income be risky despite being recognised as an asset?
For the authors reflections on these questions please go to financebook.co.uk
Where to spot in company accounts 
Prepayments and accruals can be found in the notes to the balance sheet.
- ■Prepayments and accrued income (if applicable) can be found within the debtors / receivables note. If the amounts are not material they may be included within ‘other debtors / receivables’.
- ■Accruals and deferred income can be found within the creditors / payables note. If the amounts are not material they may be included within ‘other creditors / payables’.
Extract from Greggs plc 2020 annual report and accounts
Extract from note 16 trade and other receivables. It can be seen that Greggs plc had £6m of prepayments at 2 January 2021.
| 16. Trade and other receivables | ||
|---|---|---|
| Group and Parent Company | ||
| 2020 £m | 2019 £m | |
| Trade receivables | 22.0 | 15.8 |
| Other receivables | 11.4 | 6.0 |
| Prepayments | 6.0 | 5.3 |
| 39.4 | 27.1 | |
The trade and other payables note shows that Greggs plc had £15.1m of accruals at 2 January 2021.
Greggs plc also had the following forms of deferred income at the same date:
- ■Advance payments from customers of £2.5m
- ■Deferred government grants of £0.5m
In 2019 accruals and other payables included accruals of £27.0 million for performance-related remuneration. There are no similar accruals in 2020.
Consolidate and apply
To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 395.
Watch out for in practice 
- →Liabilities/expenses for goods or services received close to the year end will need to be accounted for and due to their timing will often have to be accrued. Requesting prompt invoices or estimates from suppliers will aid the accruals process.
- →An analysis of supplier invoices received early in the financial year can help identify goods or services received in the previous financial year, which should have been accrued.
- →Unexpected differences in the year-on-year trend for prepayments and accruals.