An accrual is a cost or income that belongs to this year but has not been paid or received. A prepayment is a payment or receipt that belongs to next year. Both adjust the amount in the trial balance to match the year.
This lesson is part of year-end adjustments. The next lesson, accounting for depreciation, uses the same matching idea.
Which way does the adjustment go?
Start from the amount paid in the trial balance and ask what the year actually used. If the year used more than was paid, add the difference. If the year used less than was paid, deduct the difference.
| Case | Example | Expense or income adjustment | Statement of financial position item |
|---|---|---|---|
| Accrued expense | Unpaid electricity | Add to expense | Current liability |
| Prepaid expense | Next year’s insurance paid | Deduct from expense | Current asset |
| Accrued income | Interest earned, not yet received | Add to income | Current asset |
| Income received in advance | Commission for next year | Deduct from income | Current liability |
Worked example: year ended 31 December
Rent paid during the year is RM7 200. It includes RM1 200 for January of next year. Electricity paid is RM3 600, and RM400 is owed for December. Commission received is RM2 500, of which RM500 belongs to next year.
Rent. The year used 7 200 − 1 200 = RM6 000. The RM1 200 is a prepaid rent, a current asset.
Electricity. The year used 3 600 + 400 = RM4 000. The RM400 is an accrued expense, a current liability.
Commission. The year earned 2 500 − 500 = RM2 000. The RM500 is commission received in advance, a current liability.
The income statement uses RM6 000 for rent, RM4 000 for electricity and RM2 000 for commission. The statement of financial position shows a prepayment of RM1 200 as an asset and liabilities of RM400 and RM500.
The mistake that loses marks
The common slip is to add the prepaid amount to the expense, because “it was paid”. A cost paid for next year is not a cost of this year, so it must be deducted.
A second slip is to put an accrued expense into the statement of financial position as an asset. It is owed, so it is a liability.
Check yourself
The year ends on 31 December. Insurance of RM4 800 was paid on 1 October for 12 months. Wages paid during the year are RM24 000, and RM2 000 of wages are still unpaid. Find the insurance expense, the prepayment, and the wages expense.
Answer
Insurance for this year covers October to December, which is 3 months: 4 800 × 3 ÷ 12 = RM1 200 expense.
The prepayment is the other nine months: 4 800 − 1 200 = RM3 600, a current asset.
Wages expense = 24 000 + 2 000 = RM26 000, with RM2 000 as an accrued liability.
What to study next
Move on to accounting for depreciation. Practise the entries with the debit-credit transaction trainer.
For a teacher to go through accruals and prepayments on your own questions, see online one-to-one Accounting tuition.