The Rates Bill That Belongs to Last Year
Picture a small shop that pays its annual insurance in one go. The bill is £1,200 and it lands in October, covering the twelve months to the following September. The owner writes the cheque, the money leaves the bank, and most people would call that a £1,200 cost in October.
It is not. Three months of that cover belong to this year and nine months belong to next year. If the shop's year ends in December, only £300 of the insurance has actually been used up by the time the accounts are drawn. The other £900 is still sitting there, paid for but not yet consumed. Counting the whole £1,200 in the wrong year makes the figures lie.
Accruals and prepayments are the two adjustments that fix this kind of timing problem. They are the reason a set of accounts shows what a business genuinely earned and spent in a period, rather than just what happened to move through the bank. This guide explains both in plain English, shows the journal entries, sets out the difference between them, and covers the bit that trips up a lot of sole traders: when you are even allowed to use them in the first place.
The Idea Underneath Both: The Matching Principle
Accruals and prepayments are not separate rules to memorise. They are two faces of a single accounting idea called the matching principle, sometimes called the accruals concept.
The matching principle says costs and income should be recorded in the period they actually relate to, not the period the cash happens to move. A sale belongs to the month you delivered the goods, even if the customer pays you six weeks later. A cost belongs to the month you used the service, even if the invoice turns up afterwards or you paid for it in advance.
This is the foundation of what is called accruals basis accounting, and it is required for UK company accounts. It is written into law. The Companies Act 2006 lists "accruals" as one of the fundamental accounting principles, and FRS 102 Section 2 sets it out as the basis on which financial statements are prepared. The whole point is to make one year's accounts comparable with the next.
Accruals and prepayments are simply the housekeeping that makes the matching principle work in practice. One pulls a cost or income into the current year that the cash has not caught up with yet. The other pushes a cost or income out of the current year because the cash arrived too early.
What Is an Accrual?
An accrual is a cost your business has already used but has not yet paid for or been invoiced for at the period end. You owe the money. You just have not been billed.
The classic example is the electricity bill. Your year ends on 31 December, but the meter has been ticking all through December and the bill will not arrive until late January. The electricity was used in December, so the cost belongs in December's accounts. You estimate it, say £400, and record it now even though no invoice exists yet.
Other everyday accruals include:
- Accountancy fees for preparing the very accounts you are looking at, billed after the year end
- Staff bonuses earned in the year but paid in the next
- Interest on a loan that has built up but is not yet charged
- Wages for days worked before the year end but paid in the following period
The double entry for an accrual is:
- Debit the relevant expense in the profit and loss account
- Credit accruals, a liability on the balance sheet
So our £400 estimated electricity cost increases December's expenses by £400 and creates a £400 liability. The business has recognised the cost in the right year and shown that it still owes the money. When the real bill arrives in January, the accrual is reversed and the actual invoice is posted. If the bill comes in at £420, the small £20 difference simply lands in the new year. Estimates are allowed to be slightly wrong; that is the nature of them.
What Is a Prepayment?
A prepayment is the mirror image. It is a cost you have already paid for but have not yet used at the period end. You are in credit. The benefit is still to come.
Back to the shop and its insurance. The £1,200 was paid in October for twelve months of cover. At the 31 December year end, only three months have been used. The remaining nine months, worth £900, is a prepayment. It is money spent on something the business has not yet received the benefit of, so it does not belong in this year's costs.
Common prepayments include:
- Insurance paid annually in advance
- Rent and business rates paid quarterly or yearly up front
- Software subscriptions and licences billed for a year ahead
- Trade memberships and domain renewals covering future periods
The double entry for a prepayment is:
- Debit prepayments, an asset on the balance sheet
- Credit the relevant expense in the profit and loss account
For the insurance, you take £900 out of this year's insurance cost and park it as a £900 asset called prepayments. This year's profit and loss only carries the £300 that was genuinely used. In the new year the prepayment is released back into the insurance expense month by month as the cover is consumed.
A prepayment is an asset for a simple reason. The business has paid for something of value it has not yet received. That future benefit is worth something, so it sits on the balance sheet until it is used up.
The Difference Between Accruals and Prepayments
People search for the difference between these two constantly, and the cleanest way to see it is side by side.
| Accrual | Prepayment | |
|---|---|---|
| Cash | Not yet paid | Already paid |
| Benefit | Already used | Not yet used |
| Balance sheet | Liability (you owe) | Asset (you are owed value) |
| Effect on profit | Increases this year's costs | Reduces this year's costs |
| Typical example | December electricity, billed in January | Insurance paid yearly in advance |
The one sentence version: an accrual is expense now, cash later, and a prepayment is cash now, expense later. Once that clicks, the journal entries follow on their own. If the cost belongs in this year but the cash has not gone out, accrue it. If the cash has gone out but the cost belongs in the future, prepay it.
The Other Two Corners: Accrued and Deferred Income
Accruals and prepayments are usually taught on the cost side, but the same logic works on the income side, and any complete set of accounts uses all four. It helps to see the full grid.
| Costs | Income | |
|---|---|---|
| Belongs to this year, cash not yet moved | Accrual (liability) | Accrued income (asset) |
| Cash moved, belongs to a future year | Prepayment (asset) | Deferred income (liability) |
Accrued income is work you have done but not yet invoiced at the year end. A consultant who finished a project in late December but raises the invoice in January has earned that income in December. It is an asset, because the customer owes you for value already delivered. This is closely related to trade receivables, the difference being that a receivable usually has an invoice behind it while accrued income does not yet.
Deferred income is money a customer has paid you in advance for work you have not yet done. A gym that takes a year's membership up front has not earned all of it on day one. The unearned part is a liability, because you owe the customer the service. It sits on the same side of the balance sheet as your trade payables, as something the business still has to settle, just in service rather than cash.
Getting deferred income right matters more than people expect. We have seen businesses that take annual payments report a wonderful first quarter and a grim fourth one, purely because they booked all the cash as revenue on day one and then had nothing left to recognise. Spreading it properly smooths the picture and tells the truth about how the business is actually trading.
A Worked Example From Start to Finish
Bring it together with a single business. A design studio has a 31 December year end. Three things are outstanding at the year end.
- December's electricity has been used but not billed. Estimated cost £350
- Annual insurance of £1,200 was paid on 1 October, covering twelve months
- Accountancy fees of £900 for preparing these accounts will be billed in February
Here is what gets posted at the year end.
| Item | Adjustment | Debit | Credit |
|---|---|---|---|
| Electricity used, not billed | Accrual | Electricity expense £350 | Accruals £350 |
| Insurance, 9 months unused | Prepayment | Prepayments £900 | Insurance expense £900 |
| Accountancy fees, not billed | Accrual | Accountancy expense £900 | Accruals £900 |
After these entries, the profit and loss account carries the right cost for the year. Electricity includes the £350 that was used. Insurance shows only the £300 of cover consumed, because £900 was removed. Accountancy includes the £900 fee that relates to this year's work. The balance sheet shows £1,250 of accruals as a liability and £900 of prepayments as an asset.
None of these adjustments touch the bank. They are pure timing entries. That is the part newcomers find strange at first: real, meaningful numbers appearing in the accounts with no money moving. But that is exactly the work accruals and prepayments do. They separate what the business earned and spent from what happened to clear the bank, and the gap between those two things is often where the real story sits.
Where They Sit on the Balance Sheet
Accruals and prepayments are short-term timing items, so they live in the current section of the balance sheet alongside the other working capital balances.
- Prepayments sit under current assets, usually grouped with or near trade receivables and labelled "prepayments and accrued income"
- Accruals sit under current liabilities, usually grouped with or near trade payables and labelled "accruals and deferred income"
This is why the published accounts of most UK companies show line items called "prepayments and accrued income" and "accruals and deferred income". Those headings are the four corners of the grid above, collapsed into two tidy numbers. They are part of the same operating picture as stock, the trade balances, and the long-term items such as depreciation of fixed assets. Together they drive almost every working capital ratio worth looking at.
Accruals Basis or Cash Basis? The Bit Sole Traders Miss
Everything above assumes you are preparing accounts on the accruals basis. For limited companies that is not optional; it is required. For the self employed, there is a genuine choice, and it changes whether accruals and prepayments apply to you at all.
HMRC lets most sole traders and partnerships use the cash basis, where you record income when the money actually arrives and costs when you actually pay them. On the cash basis there are no accruals and no prepayments. The October insurance payment is simply a cost in October, full stop. It is simpler, and for many small, straightforward businesses it is the sensible default. The cash basis is now the default method for sole traders, and you have to actively elect out of it if you want the accruals basis instead. The rules are set out on GOV.UK's cash basis guidance.
So which is right? Our honest view is that it depends on how your business carries its costs and income through time.
- The cash basis suits businesses where money in and money out roughly track the underlying activity. A mobile hairdresser paid on the day, with few large advance payments, gains little from accruals accounting and a lot from its simplicity
- The accruals basis earns its keep the moment timing gaps get large. If you invoice on thirty day terms, hold stock, pay for things well in advance, or want accounts a lender or buyer will take seriously, the accruals basis gives a far truer picture of profit
There is also a planning angle people forget. Because the cash basis ignores prepayments, a deliberate prepayment near the year end can pull a cost into the current tax year. That can be useful, but it is a blunt tool and only ever a timing shift, not a real saving. It is the kind of thing worth a five minute conversation as part of proper tax planning rather than a reason to pick your whole accounting method.
What Businesses Get Wrong
A few patterns we see again and again when we pick up a new client's books.
- Nothing is accrued at all. The accounts only reflect invoices that happened to arrive before the year end, so costs are understated and profit is flattered. The first proper year end then comes as a shock when the missing costs all land at once
- Prepayments are forgotten on renewal. A year of insurance or software is paid up front and booked entirely as a cost, year after year, with no prepayment carried forward. Over a few renewals the timing distortion compounds
- Deferred income is booked as revenue on day one. Businesses that take annual payments up front report lumpy, misleading results because they recognise all the cash immediately instead of spreading it across the service period
- Accruals are never reversed. An estimate is accrued one year and left sitting on the balance sheet because the real invoice was posted separately the next year. Now the cost is counted twice. A reconciliation of the accruals account each year catches this in minutes
None of these is dramatic in isolation. Across a couple of years and a growing business, they add up to management accounts you cannot trust, which is the one thing accounts are supposed to be.
Good cloud accounting software takes most of the pain out of this. We use Xero with most clients, and its repeating journals and prepayment tools mean a year of insurance can be spread across twelve months automatically the moment it is entered. The mechanics stop being a manual chore and the figures stay honest month to month.
How IAK Can Help
Accruals and prepayments are not complicated once the idea lands, but the discipline of doing them properly every period is exactly the sort of thing that slips when a business is busy. We handle them as a standard part of the month end and year end for our accounting and bookkeeping clients, and we review the position for new clients to make sure last year's estimates were actually reversed and this year's costs sit where they belong.
If you are not sure whether your accounts are on the right basis, whether your prepayments are being carried forward, or whether your year end adjustments hold up, that is a quick and worthwhile conversation. Take a look at our accounting, bookkeeping and management reporting services, or contact us and tell us roughly how your business takes money in and pays it out. We will tell you straight which basis fits and whether anything needs tidying up.