Table of Contents
Accruals and Prepayments: Definition, Uses and Examples
- CLFI Team
- 4 min read
Accruals and prepayments are two fundamental concepts in accruals accounting, ensuring that income and expenses are recognised in the correct accounting period. They allow businesses to apply the matching principle, which links revenues with the costs incurred to generate them. Understanding accrued expenses (accruals) and prepaid expenses (prepayments) helps readers interpret both the income statement and the balance sheet correctly.
The Principle Behind Accruals and Prepayments
Accrual accounting records transactions when they occur, not when cash changes hands. At the end of each period, accountants make adjustments for revenues earned but not yet received, and for expenses incurred but not yet paid. Similarly, prepayments are future expenses that have already been paid, requiring an adjustment to defer them to the correct period. These entries keep financial statements accurate and ensure profits are not distorted by timing differences.
Definition:
Accrued Expenses (Accruals)
Expenses that have been incurred but not yet paid by the end of the accounting period. They are recognised as liabilities on the balance sheet and as expenses in the income statement.
Definition:
Prepaid Expenses (Prepayments)
Payments made in advance for goods or services to be received in future periods. They are recorded as assets on the balance sheet and gradually expensed as the benefit is used.
Accruals vs Prepayments — Key Differences
| Aspect | Accruals (Accrued Expenses) | Prepayments (Prepaid Expenses) |
|---|---|---|
| Meaning | Expenses incurred but not yet paid. | Expenses paid in advance for future periods. |
| Balance Sheet Classification | Current liability (accrued expenses). | Current asset (prepayments). |
| Effect on Profit | Increases expenses and reduces profit. | Decreases current period expenses and increases profit. |
| Adjustment Type | Expense accrued at period end. | Expense deferred until future periods. |
| Example | Utility bill for December received in January. | Insurance paid in December covering next year. |
Example: Recording an Accrual and a Prepayment
Let’s explore how both accrued expenses and prepaid expenses are recognised and posted. Each entry shows how the adjustment ensures that the expense appears in the correct period under the matching principle.
Accruals and Prepayments Adjustments
How adjusting entries ensure accurate profit and balance sheet presentation.
Scenario 1 — Accrual: At year-end, the electricity company has supplied power worth £1,200, but the bill will arrive next month. Scenario 2 — Prepayment: The business paid £2,400 for annual insurance in December, covering the next 12 months.
The first entry recognises the accrued expense for electricity — a cost incurred but not yet paid, creating a liability. The second entry defers part of the prepaid expense for insurance, reducing current period expenses and creating an asset to be expensed later.
Record the year-end adjustments
Post to the ledger accounts
After posting, we can see how each adjustment changes the period-end balances.
| Accrued Expenses (Liability) | ||
|---|---|---|
| Date | Debit | Credit |
| 31 Dec 2025 | — | £1,200 |
| Balance | £1,200 (Credit) | |
| Prepaid Insurance (Asset) | ||
|---|---|---|
| Date | Debit | Credit |
| 31 Dec 2025 | £2,400 | — |
| Balance | £2,400 (Debit) | |
Reflect on the balance sheet impact
Learning takeaway
Accruals and prepayments keep the financial statements aligned with economic reality. They ensure that each period’s income statement shows only the costs and revenues that belong to that period — a cornerstone of matching principle accounting.
Interpretation. Understanding accruals and prepayments allows managers to assess whether profits reflect true performance rather than timing differences. On the balance sheet, accruals increase liabilities and prepayments increase assets; on the income statement, they adjust expenses to match the correct period.
In Practice
In practice, accruals and prepayments are the adjustment tools that make accounting information meaningful. They ensure that financial statements reflect not when cash moves, but when value is created or consumed. For managers, this means the profit figure they see each month is not distorted by payment timing, but represents the true economic activity of the business. Accruals bring forward costs that have been incurred but unpaid; prepayments defer costs that belong to future periods — together, they anchor reporting accuracy.
From a financial management perspective, these adjustments directly affect key performance ratios. Accruals increase short-term liabilities, impacting liquidity indicators such as the current ratio or working capital. Prepayments, by contrast, increase current assets, improving those same metrics but reducing immediate expense recognition. Analysts and board members rely on these adjustments to interpret operational efficiency and cash flow discipline — knowing whether expenses are genuinely rising or merely being timed differently.
In the wider context of the Accounting Series, mastering accruals and prepayments builds the foundation for understanding more advanced topics such as cash flow analysis, profitability ratios, and earnings quality. These concepts show how timing adjustments translate into managerial insight: how a company earns, spends, and reports value over time. Without them, subsequent measures — from return on assets (ROA) to valuation multiples — would lose their meaning.
Definition
Balance Sheet
A financial statement showing what a business owns and owes at a specific point in time, summarising assets, liabilities, and equity. For a step-by-step guide to interpreting it, read How to Read a Balance Sheet – Finance for Non-Finance Managers .
Programme Content Overview
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Chart: Percentage weighting of each core course within the CLFI Executive Certificate curriculum.
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