## **Learning Outcomes**

After studying this article, you will be able to explain the principles of accruals and prepayments, prepare the necessary adjusting journal entries, and accurately post these entries to the relevant general ledger accounts. You will also be able to identify the financial statement impact of accruals and prepayments—ensuring expenses and incomes are matched to the correct accounting period.

## **ACCA Maintaining Financial Records (FA2) Syllabus**

For ACCA Maintaining Financial Records (FA2), you are required to understand how to apply the accruals concept when recording expenses and income, and how to accurately process related year-end adjusting journals and ledger postings. Specifically, you should be able to:

- Apply the accruals basis of accounting to record expenses and income in the correct accounting period
- Calculate accruals and prepayments for expenses and income
- Prepare adjusting journal entries for accruals and prepayments
- Post adjusting entries to the relevant general ledger accounts
- Demonstrate the effect of accruals and prepayments on both financial performance and position
- Present accruals, prepayments, accrued income, and deferred income in the financial statements

## **Test Your Knowledge**

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

1. An invoice for repairs of \$800 relating to the last month of the year has not been received or paid by the year-end. What is the double-entry to record this?
2. Which general ledger account(s) are debited and credited when recording a prepayment for annual insurance at year-end?
3. State whether an accrual appears as a current asset or current liability in the statement of financial position.
4. True or false? A prepayment reduces the expense charged to the statement of profit or loss for the year.

## **Introduction**

Accruals and prepayments ensure that income and expenses are recognised in the correct accounting period, regardless of cash flows. This adjustment is fundamental for producing accurate financial statements under the accruals basis. Recording these items correctly requires both calculating the necessary adjustments and making accurate journal entries and ledger postings. Misposting can lead to misstated profits and assets or liabilities, so achieving proficiency in this skill is a key exam area.

> **Key Term: accruals concept**
> Income and expenses must be recognised in the period in which they are earned or incurred, not simply when cash is received or paid.

## **Understanding Accruals and Prepayments**

### Accruals

An **accrual** records an expense (or income) that relates to the current accounting period but has not yet been paid (or received) by period end. Without the accrual, some expenses would be missing from the accounts, understating liabilities and overstating profit.

> **Key Term: accrual**
> An expense incurred in the period but not yet paid, recognised in the accounts by increasing both expenses and liabilities.
>
> **Key Term: accrued income**
> Income earned in the period but not yet received, recognised as an asset in the accounts.

### Prepayments

A **prepayment** is where cash has been paid (or received) in advance for expenses (or income) relating to a future period. Prepayments ensure expenses or income are matched to the period they relate to, not when the cash moved.

> **Key Term: prepayment**
> An advance payment for goods or services relating to a future period, treated as a current asset until that period arrives.
>
> **Key Term: deferred income**
> Income received before it has been earned—recognised as a current liability until the related service or goods have been provided.

## **Journal Entries for Accruals and Prepayments**

Accounting for accruals and prepayments requires creating year-end journal entries to adjust expense and income accounts to the correct amounts for the period.

### Accrued Expenses

**Accrued expenses** increase both the expense in the profit or loss account and current liabilities.

#### Journal Entry (Year-End Accrual)

- **Debit:** Expense account (e.g. Electricity, Wages)
- **Credit:** Accruals (current liability)

This increases the expense and sets up a liability for the amount owed.

#### Reversal (Next Period)

At the start of the next period, the accrual is reversed, as payment is likely to be made in the current period.

- **Debit:** Accruals
- **Credit:** Expense account

### Prepaid Expenses

**Prepaid expenses** reduce expenses in the statement of profit or loss and create an asset for the unused portion.

#### Journal Entry (Year-End Prepayment)

- **Debit:** Prepayments (current asset)
- **Credit:** Expense account

This moves the unused portion of the expense to the statement of financial position.

#### Recognition in Next Period

As the prepaid service is consumed, the prepayment is released:

- **Debit:** Expense account
- **Credit:** Prepayments

### Accrued Income and Deferred Income

- **Accrued income:**
  - **Debit:** Accrued income (current asset)
  - **Credit:** Income account

- **Deferred income:**
  - **Debit:** Income account
  - **Credit:** Deferred income (current liability)

## **Ledger Account Postings**

Journal entries must then be posted to the relevant accounts:

- Accruals and accrued income create _balances carried forward_ to the statement of financial position as liabilities or assets.
- Prepayments and deferred income are likewise carried forward as assets or liabilities.
- At the start of the new period, these balances are reversed and the related payment or receipt will clear the balance.

### **Worked Example 1.1**

A business's year-end is 31 December. It pays telephone bills quarterly in arrears. At 31 December, the last bill of \$420 covers up to 30 November. One month's expense for December is unrecorded and estimated at \$140.

_What is the journal entry to account for the missing expense?_

> **Answer:**
>
> Debit: Telephone expense \$140  
> Credit: Accruals \$140  
> This records the cost for December in the current period and increases liabilities for the unpaid amount.

### **Worked Example 1.2**

Business A pays \$1,200 on 1 April for 12 months of insurance cover in advance. Its year-end is 31 December.

_How should the unused portion be adjusted at year-end, and what is the journal entry?_

> **Answer:**
>
> As 3 months’ cover applies to the next accounting year, a prepayment is needed:  
> Debit: Prepayments \$300  
> Credit: Insurance expense \$300  
> This reduces the expense to match only the months relating to the current year.

### **Exam Warning**

> Sometimes prepayments and accruals are confused in both journal entries and the placement in financial statements. Remember:
>
> - Accruals and deferred income are liabilities (amounts owed to others)
> - Prepayments and accrued income are assets (amounts owed to you)

## **Summary**

Accruals and prepayments ensure income and expenses reflect only amounts relating to the current accounting period. This is achieved through adjusting journal entries and correct ledger postings:

- Accruals increase expenses/liabilities
- Prepayments reduce expenses and create assets
  Correctly processing these entries is essential for accurate profit reporting and financial statements.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Explain the accruals concept and why adjustments are required for period-end accounting
- Calculate accruals and prepayments for expenses and income
- Prepare journal entries for year-end accruals and prepayments
- Post adjustments to the correct expense and balance sheet accounts
- Identify whether an entry is a current asset or current liability
- Reverse accruals and prepayments properly at the start of the new period
- Demonstrate the impact on financial statements

## **Key Terms and Concepts**

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

Accruals and prepayments - Journal entries and ledger postings