Lesson 9 — Accruals and Prepayments | O Level Accounting

📘 Lesson 9 of 16

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1. The Accruals Concept 7707 / 3.6

In accounting, income and expenses are recognised when they are earned or incurred, not when cash is received or paid. This is the accruals concept (also called the matching principle).

Accruals Concept: Income and expenses must be matched to the accounting period in which they relate, regardless of when the cash actually moves. Financial statements should reflect what was earned and what was owed — not just what was received and paid.

In practice, at the end of an accounting year, some expenses and incomes may not perfectly align with the cash paid or received. Two adjustments are needed:

Accrual (Accrued Expense)

An expense that has been incurred during the period but has not yet been paid. The business owes this amount at the year end.

Example: Electricity used in December but the bill arrives in January.

Prepayment (Prepaid Expense)

An expense that has been paid in advance for a future period — part of the payment relates to next year, not this year.

Example: Insurance paid in October covering the next 12 months.

📌 Key Rule: The Income Statement must show only the expense or income that belongs to this accounting period — nothing more, nothing less. Accruals and prepayments are the tool to achieve this.

2. Accrued Expenses (Accruals)

An accrued expense arises when a business has used a service during the year but has not yet paid for it at the year end. The expense has been incurred — it must be included in this year's Income Statement even though no cash has been paid.

Effect on Financial Statements

Statement	Treatment of Accrued Expense
Income Statement	Add the accrued amount to the cash paid → gives the correct expense for the period
Statement of Financial Position	Show as a current liability (accruals) — the business owes this amount

Accrued Expense — Adjustment Formula

Expense in Income Statement = Cash paid + Accrual at year end − Accrual from previous year end

Ledger Account with Accrual

📋 Example 1: Rent Expense with Accrual

During the year ended 31 December 2026, a business paid $9,000 rent in cash. At 31 December 2026, rent of $1,500 is still owing (accrued). There was no accrual at the start of the year.

Expense for Income Statement = 9,000 + 1,500 = $10,500

Rent Expense Account — Year ended 31 Dec 2026

Details	$
Cash / Bank (paid)	9,000
Accrual c/d ✦	1,500
Total	10,500
Accrual b/d (next year)	1,500

Details	$
Income Statement	10,500
Total	10,500

✦ Accrual c/d appears on the DR side of the expense account as a balancing figure — it increases the expense to the correct amount. It is then brought down on the DR side as a current liability at the start of the next period (it will be paid next year but relates to this year).

💡 In the SFP: Accrued rent of $1,500 appears under Current Liabilities as "Accruals" or "Accrued expenses".

Accrual Carried Forward — Effect in Next Year

📋 Example 1 continued: Next year (2027)

In 2027, the business pays $11,000 rent in cash. At 31 Dec 2027, rent accrued is $2,000. There was a b/d accrual of $1,500 from 2026.

Expense for Income Statement 2027 = 11,000 + 2,000 − 1,500 = $11,500

Rent Expense Account — Year ended 31 Dec 2027

Details	$
Accrual b/d (from 2026)	1,500
Cash / Bank (paid)	11,000
Accrual c/d ✦	2,000
Total	14,500

Details	$
Income Statement	11,500
Total	11,500

⚠️ Note on the b/d accrual: The accrual brought down at the start of 2027 is on the DR side of the account — this is because when it is actually paid in 2027, it is already covered by the b/d balance and does not increase the 2027 expense. The Income Statement amount is correctly calculated as only the 2027 expense.

3. Prepaid Expenses (Prepayments)

A prepaid expense arises when a business pays for something in advance — part of the payment covers a future period and must not be charged to this year's Income Statement.

Effect on Financial Statements

Statement	Treatment of Prepaid Expense
Income Statement	Subtract the prepaid amount from cash paid → gives the correct expense for the period
Statement of Financial Position	Show as a current asset (prepayments) — the business has paid in advance and is owed this benefit

Prepaid Expense — Adjustment Formula

Expense in Income Statement = Cash paid − Prepayment at year end + Prepayment from previous year end

Timeline Visualisation

Oct 2026
Pay insurance
$12,000

Cash paid

Oct–Dec 2026
(3 months)
$3,000

This year's expense ✓

Jan–Sep 2027
(9 months)
$9,000

Prepayment → next year

Ledger Account with Prepayment

📋 Example 2: Insurance Expense with Prepayment

On 1 October 2026 a business pays $12,000 insurance for 12 months (covering Oct 2026 – Sep 2027). Year end is 31 December 2026. No prepayment existed at the start of the year.

This year's expense = 3 months out of 12 = 12,000 × 3/12 = $3,000
Prepayment c/d = 9 months = 12,000 × 9/12 = $9,000

Insurance Expense Account — Year ended 31 Dec 2026

Details	$
Cash / Bank (paid)	12,000
Total	12,000

Details	$
Prepayment c/d ✦	9,000
Income Statement	3,000
Total	12,000
Prepayment b/d (next year)	9,000

✦ Prepayment c/d appears on the CR side of the expense account — it reduces the expense charged to this year's Income Statement. It is carried down on the CR side as a current asset at the start of next period (the business has paid in advance and is owed the benefit).

💡 In the SFP: Prepaid insurance of $9,000 appears under Current Assets as "Prepayments" or "Prepaid expenses".

4. Adjustments for Income Accounts Also Examined

The same accruals concept applies to income accounts. A business may have earned income it has not yet received, or received income that belongs to a future period.

Accrued Income (Income Due)

Income earned in the current period but not yet received in cash.

Income Statement: Add accrued income to cash received.

SFP: Show as a current asset.

Example: Rent receivable for December not yet received.

Income Received in Advance (Deferred Income)

Income received in cash but which relates to a future period.

Income Statement: Subtract from cash received.

SFP: Show as a current liability.

Example: Rent received in December for January next year.

Summary — All Four Adjustments

Type	Nature	Effect on I/S	SFP Position	Ledger: Closing Side
Accrued Expense	Expense incurred, not yet paid	Add to expense	Current Liability	DR side of expense a/c
Prepaid Expense	Expense paid in advance for future period	Subtract from expense	Current Asset	CR side of expense a/c
Accrued Income	Income earned, not yet received	Add to income	Current Asset	CR side of income a/c
Income Received in Advance	Income received for future period	Subtract from income	Current Liability	DR side of income a/c

💡 Quick Memory Rule:
Expense accrual → add to expense → current liability
Expense prepayment → subtract from expense → current asset
Income accrual → add to income → current asset
Income received in advance → subtract from income → current liability

5. Full Worked Example — Multiple Adjustments

📋 Example 3: Prepare Adjusted Expense Accounts

The following information relates to the year ended 31 December 2026:

Item	Cash Paid/Received ($)	Opening Balance ($)	Closing Balance ($)
Wages expense	48,000 paid	Accrual b/d: 2,000	Accrual c/d: 3,500
Insurance expense	6,000 paid	Prepayment b/d: 1,200	Prepayment c/d: 900
Rent receivable (income)	5,400 received	None	Accrued income c/d: 600

Wages Expense Account

Wages Expense Account — 2026

Details	$
Accrual b/d	2,000
Cash / Bank	48,000
Accrual c/d	3,500
Total	53,500

Details	$
Income Statement	53,500
Total	53,500

I/S wages = 48,000 + 3,500 − 2,000 = $49,500

Insurance Expense Account

Insurance Expense Account — 2026

Details	$
Prepayment b/d	1,200
Cash / Bank	6,000
Total	7,200

Details	$
Prepayment c/d	900
Income Statement	6,300
Total	7,200

I/S insurance = 6,000 − 900 + 1,200 = $6,300

Rent Receivable Account (Income)

Rent Receivable Account — 2026

Details	$
Income Statement	6,000
Total	6,000

Details	$
Cash / Bank	5,400
Accrued income c/d	600
Total	6,000
Accrued income b/d	600

I/S rent income = 5,400 + 600 = $6,000

Summary of SFP entries at 31 Dec 2026:
Current Liabilities: Accrued wages $3,500
Current Assets: Prepaid insurance $900 | Accrued rent receivable $600

6. Quick Reference — Ledger Account Rules

Adjustment Type	Opening b/d side	Closing c/d side	I/S charge side
Accrued Expense	DR (already a liability from last year — increases expense DR side)	DR (new liability — balances CR side)	CR (total expense transferred out)
Prepaid Expense	CR (asset from last year — reduces next year's cash impact)	CR (new asset — reduces DR side total)	CR (reduced expense transferred out)
Accrued Income	DR (asset b/d from last year)	CR (new asset — increases income)	DR (total income transferred out)
Income Received in Advance	CR (liability from last year — reduces income)	DR (new liability — reduces income)	DR (reduced income transferred out)

🧠 Memory Aid — Which Side is the Closing Balance?

Accrued expense c/d → DR side (it will be paid next year — a liability)
Prepaid expense c/d → CR side (it will be used next year — an asset reduces the account)
Accrued income c/d → CR side (it will be received next year — an asset)
Income received in advance c/d → DR side (it will be earned next year — a liability)

7. Common Mistakes

⚠️ Mistake 1 — Forgetting the opening balance: If there is a b/d accrual or prepayment from the previous year, it must be included on the correct side of the ledger account. Ignoring the opening balance gives a wrong I/S figure.

⚠️ Mistake 2 — Putting the closing balance on the wrong side: A closing accrual (expense) goes on the DR side (it is a liability — owed but not paid). A closing prepayment (expense) goes on the CR side (it is an asset — paid but not yet used). Mixing these up is the most common error in this topic.

⚠️ Mistake 3 — Confusing SFP classification: Accrued expenses are current liabilities. Prepaid expenses are current assets. Students regularly swap these. Link it to logic: an accrual is money you owe → liability. A prepayment is money you have paid in advance and are owed the benefit → asset.

⚠️ Mistake 4 — Applying prepayments proportionally: Always check whether the question asks for a time-proportion calculation. If insurance is paid for 12 months starting 1 October and the year end is 31 December, only 3 of the 12 months are in this year. Show your working clearly — examiners award method marks.

⚠️ Mistake 5 — Accrued income on wrong SFP side: Accrued income is a current asset (the business is owed money). Income received in advance is a current liability (the business owes a service). These are frequently confused.

📝 Exam Practice Questions

Question 1 Knowledge — 2 marks

Distinguish between an accrued expense and a prepaid expense.

An accrued expense is an expense that has been incurred during the accounting period but has not yet been paid. It is a current liability in the Statement of Financial Position. (1 mark)

A prepaid expense is an expense that has been paid in advance — part of the payment relates to a future accounting period and should not be charged to the current Income Statement. It is a current asset. (1 mark)

Question 2 Application — 4 marks

During the year ended 30 June 2026, a business paid $7,200 electricity in cash. At 30 June 2026, electricity owing (accrued) was $800. At 1 July 2025, there was an accrual of $500 brought forward.

Prepare the Electricity Expense Account for the year ended 30 June 2026 and state the amount transferred to the Income Statement.

Electricity Expense Account — Year ended 30 June 2026

Details	$
Accrual b/d	500
Cash / Bank	7,200
Accrual c/d	800
Total	8,500

Details	$
Income Statement	8,500
Total	8,500

Income Statement charge = $7,500
Working: 7,200 + 800 − 500 = $7,500
The ledger account total is $8,500 (includes b/d accrual) but the I/S amount is $7,500.

📌 Do not confuse the ledger account total ($8,500) with the Income Statement charge ($7,500). These are different figures.

Question 3 Application — 4 marks

A business pays insurance on 1 September each year. On 1 September 2025, it pays $4,800 for 12 months. The accounting year end is 31 December 2025. There was no prepayment at the start of the year.

Prepare the Insurance Expense Account and state the amount shown in the Statement of Financial Position.

This year: Sep–Dec 2025 = 4 months out of 12
Expense = 4,800 × 4/12 = $1,600
Prepayment c/d = 4,800 × 8/12 = $3,200

Insurance Expense Account — Year ended 31 Dec 2025

Details	$
Cash / Bank	4,800
Total	4,800

Details	$
Prepayment c/d	3,200
Income Statement	1,600
Total	4,800
Prepayment b/d	3,200

SFP: Prepaid insurance of $3,200 is shown as a Current Asset in the Statement of Financial Position at 31 Dec 2025.

Question 4 Application — 3 marks

State how each of the following items would appear in the Statement of Financial Position and under which heading:

Accrued wages of $1,200
Prepaid rent of $800
Commission received in advance of $450

Accrued wages $1,200 → Current Liability (Accruals / Accrued expenses) (1 mark)
Prepaid rent $800 → Current Asset (Prepayments / Prepaid expenses) (1 mark)
Commission received in advance $450 → Current Liability (Income received in advance / Deferred income) (1 mark)

Question 5 Analysis — 5 marks

The following information is available for the year ended 31 March 2026:

Item	$
Rent paid (cash)	15,000
Accrued rent at 1 April 2025 (opening)	1,200
Accrued rent at 31 March 2026 (closing)	1,800
Motor expenses paid (cash)	8,400
Prepaid motor expenses at 1 April 2025 (opening)	600
Prepaid motor expenses at 31 March 2026 (closing)	400

Calculate the amounts to be shown in the Income Statement for: (a) Rent expense (b) Motor expenses

(a) Rent expense:
= Cash paid + Closing accrual − Opening accrual
= 15,000 + 1,800 − 1,200 = $15,600 (2 marks: 1 for method, 1 for answer)

(b) Motor expenses:
= Cash paid − Closing prepayment + Opening prepayment
= 8,400 − 400 + 600 = $8,600 (2 marks: 1 for method, 1 for answer)

📌 Formula check:
Accrued expense → + closing, − opening accrual
Prepaid expense → − closing, + opening prepayment
Always show the formula and working — method marks are available even if the final figure is wrong.

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