## Learning Outcomes

After studying this article, you will be able to explain accruals and prepayments and their role in matching expenses and income to the correct accounting period. You will understand how to calculate and record accruals and prepayments, make period-end adjustments, and report them accurately in financial statements as required by ACCA FA2.

## ACCA Maintaining Financial Records (FA2) Syllabus

For ACCA Maintaining Financial Records (FA2), you are required to understand how the accruals basis is applied to ensure correct reporting of expenses and income. You should focus your revision on:

- Applying the accruals basis of accounting to expenses and income
- Calculating adjustments for accruals and prepayments at period end
- Recording and posting journal entries for accruals and prepayments
- Identifying the effect of accruals and prepayments on profit, assets, and liabilities
- Reporting accruals and prepayments in the final financial statements

## Test Your Knowledge

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, look more closely at that area during your revision._

1. An invoice for insurance covering 1 October Year 1 to 31 March Year 2 is paid in October Year 1. How much should be charged to insurance expense for the year ending 31 December Year 1?
2. If a business receives utility bills quarterly in arrears, what adjustment is needed at period end to ensure the full expense for the period is recorded?
3. Which financial statement shows accruals as a liability and prepayments as an asset?
4. True or false? When the accruals basis is applied, expenses are reported in the period they are incurred, not when they are paid.

## Introduction

Accruals and prepayments are key in ensuring financial statements reflect the true profit or loss for a period. The accruals concept matches income and expenses to the accounting period in which they are earned or incurred, regardless of when cash is received or paid. Understanding how to identify, calculate, record, and present accruals and prepayments is essential for accurate financial reporting and common in ACCA FA2 assessments.

> **Key Term: accruals concept**
> The accounting principle that transactions are recorded in the periods to which they relate, not necessarily when cash changes hands.
>
> **Test Tip:**
> When revising Expense and income matching, connect each definition, method, or rule to the kind of question the assessment is likely to ask.

### Expense and Income Matching

Correctly matching income and expenses to the period they relate to is a fundamental accounting requirement.

### Why Matching Matters

The purpose of matching is to ensure that reported profit or loss reflects activities in the period, not just cash movements. Without matching, expenses paid in advance or expenses not yet invoiced would result in misstated profits and unbalanced financial statements.

### Accruals

An accrual represents an expense incurred or income earned during a period but not yet paid or received by period end.

> **Key Term: accrual**
> An expense or income item recognized in the accounts before cash is paid or received, representing an amount owed or due at period end.

### Prepayments

A prepayment arises when a business pays for goods or services in advance of the period to which the expense relates.

> **Key Term: prepayment**
> An expense paid in advance of the accounting period to which it relates, recognized as an asset until the benefit is received.

### Calculating and Recording Accruals and Prepayments

Adjustments for accruals and prepayments ensure that only the expenses and income that belong to the period are included in profit or loss.

![Period-end adjustments for accruals, prepayments, accrued income, and deferred income from identification through measurement, journal posting, and financial statement presentation.](https://static.pastpaperhero.com/images/acca-fa2-accruals-and-prepayments-expense-and-income-matching_00.png)

_Matching adjustments identify reporting-date items, classify income and expense timing differences, calculate period allocations, and present balances in the financial statements._

### Accrued Expenses

If a business has used goods or services but not yet received an invoice or made payment, an accrual must be recorded.

- Debit: Relevant expense (to increase expense in profit or loss)
- Credit: Accruals (current liabilities in statement of financial position)

### Prepaid Expenses

If a payment relates to a future period, part of the payment is treated as a prepayment.

- Debit: Prepayments (current asset in statement of financial position)
- Credit: Relevant expense (to reduce expense in profit or loss)

### Accrued Income

Income earned but not yet received by period end is recorded as accrued income (asset).

### Deferred Income

Income received in advance for future periods is deferred income (liability).

### Worked Example 1.1

A business pays \$1,200 for an annual insurance policy on 1 April. Its year-end is 31 December. How much is charged as an expense, and what is reported as a prepayment at year end?

> **Answer:**
> The policy covers 12 months from 1 April. By 31 December, 9 months of benefit (\$1,200 × 9/12 = \$900) relate to the current year. The remaining 3 months (\$1,200 × 3/12 = \$300) are a prepayment. Record \$900 as insurance expense and \$300 as a prepayment (current asset).

### Worked Example 1.2

A company receives a utility bill for \$400 in January for electricity used in October–December of the previous year. The year-end is 31 December. How is this expense matched to the correct period?

> **Answer:**
> The expense relates to the previous financial year, even though the bill arrives after year end. At 31 December, an accrual of \$400 must be recognized by debiting electricity expense and crediting accruals. When paid, debit accruals and credit cash.

### Worked Example 1.3

A business rents a storage unit at \$600 per month, payable quarterly in advance. On 1 December it pays \$1,800 covering December to February. What is the prepayment at 31 December?

> **Answer:**
> The payment covers December (\$600), January (\$600), and February (\$600). At 31 December, \$1,200 (Jan, Feb) is a prepayment—debit prepayments \$1,200, credit rent expense \$1,200.
>
> **Exam Warning:**
> Watch for the exam trap of charging all amounts paid in a period as an expense. Always check whether an adjustment for advance payments or unpaid invoices is needed.

### Reporting Accruals and Prepayments in the Financial Statements

- **Profit or Loss:** Expenses and income are adjusted so that only amounts relating to the current period are shown.
- **Statement of Financial Position:** Accruals increase liabilities; prepayments increase current assets.

> **Key Term: accrued income**
> Income earned in a period but not yet received at period end, recognized as an asset.
> **Key Term: deferred income**
> Income received in advance for goods or services to be provided in future periods, recognized as a liability.

## Summary

Accruals and prepayments are essential to match income and expenses to the right period. Adjustments must be calculated and recorded at period end to ensure the profit or loss figure is accurate and assets and liabilities are correctly stated.

## Key Point Checklist

_This article has covered the following key knowledge points:_

- State and apply the accruals concept for expense and income matching
- Define accruals, prepayments, accrued income, and deferred income
- Calculate and record adjustments for accruals and prepayments
- Make accurate journal entries and ledger postings for accruals and prepayments
- Present accruals (liability) and prepayments (asset) in the financial statements

## Key Terms and Concepts

- accruals concept
- accrual
- prepayment
- accrued income
- deferred income


Accruals and prepayments - Expense and income matching