Accruals and prepayments explained: what do they mean for your business?

If you’ve ever looked at your business accounts and wondered why an expense appears before you’ve paid for it, or why a payment you’ve already made isn’t included in full, the answer may involve accruals and prepayments.

These accounting adjustments help make sure your accounts reflect what’s happened in your business during a particular period, regardless of when money changes hands.

But what exactly are accruals and prepayments, and how do they affect your profits? Let’s take a look, starting with the difference between the two.

What are accruals and prepayments?

Accruals and prepayments are adjustments that put business expenses into the correct accounting period. They’re used when you prepare accounts using the accruals basis, sometimes called traditional accounting.

An accrual is an expense your business has incurred but hasn’t yet been invoiced for.

A prepayment is the opposite. It’s an expense you’ve already paid, but which relates partly or entirely to a future accounting period.

For example, you might receive an electricity bill in April for energy that you used in March. Alternatively, you might pay a year’s business insurance in January, even though your financial year ends in March.

Both situations need accounting adjustments so that your expenses appear in the periods to which they relate.

What are accruals in accounting?

An accrual allows you to recognise an expense before you’ve received the invoice.

Let’s say your company’s financial year ends on 31st March. You’ve used electricity throughout March, but your supplier won’t send the bill until April.

You estimate that the electricity you’ve used during March will cost £400, excluding any recoverable VAT.

Although you haven’t received the bill, the expense belongs in the financial year ending 31st March.

You therefore make an accrual of £400 in your accounts.

This increases your expenses for the year by £400, reducing your reported profit by the same amount. The accrual also appears as a liability on your balance sheet because you still owe the money.

When the electricity bill arrives, you’ll transfer the accrued amount to trade creditors, adjusting the figure if your estimate was incorrect.

Other common examples of accrued expenses include professional fees for work already carried out but not yet billed, interest on business loans that has accrued but hasn’t yet been charged, and wages earned by employees but not yet processed through payroll.

What are prepayments in accounting?

Prepayments work the other way round. They occur when your business pays for something before receiving the full benefit.

Imagine you pay £2,400 for 12 months of business insurance on 1st January. Your financial year ends on 31st March.

By the year-end, you’ve used three months of the insurance cover. The remaining nine months relate to the following financial year.

Your accounts would therefore show:

• Insurance expense for the current year: £600
• Prepayment carried forward: £1,800

The £600 is included as an expense in your profit and loss account. Meanwhile, the remaining £1,800 appears as an asset on your balance sheet because you’ve paid for insurance cover you’ll receive in the future.

Over the following nine months, the £1,800 will be recognised as an expense as the cover is provided.

Other examples of prepayments include annual software subscriptions, maintenance contracts and business rent paid in advance.

Of course, not every payment made in advance needs a prepayment adjustment. The amount involved, its significance to your accounts and the accounting period it covers all need to be considered.

Accruals and prepayments examples: how do they affect profit?

The easiest way to understand accruals and prepayments is to see what happens to your reported profit.

Suppose your business has made a profit of £50,000 before making its year-end accruals and prepayments adjustments.

Your accountant identifies two items:

1. An unpaid electricity expense of £400 that relates to the financial year just ended and hasn’t yet been invoiced.
2. A £1,800 insurance prepayment that relates to the following financial year.

The electricity accrual increases your expenses by £400, reducing profit to £49,600.

The insurance prepayment removes £1,800 from expenses that were initially recorded in the current year, increasing profit to £51,400.

Your adjusted profit is therefore £51,400.

Notice that neither adjustment changes the amount of money in your bank account. The electricity bill remains unpaid, while you’ve already paid for the insurance.

Accruals and prepayments change when expenses are recognised in your accounts, not when money enters or leaves your business.

What about accrued income?

So far, we’ve concentrated on expenses. However, the accruals basis also applies to income.

Accrued income is money your business has earned but hasn’t yet invoiced or received.

For example, suppose you’ve completed £3,000 worth of consultancy work by 31st March but won’t invoice your customer until April.

Assuming the income meets the relevant accounting recognition requirements, it belongs in the financial year ending 31st March.

Your accounts would therefore include £3,000 of accrued income, increasing both your reported profit and the assets shown on your balance sheet.

When you subsequently raise the invoice, the accrued income balance can be transferred to trade debtors.

There’s also something called deferred income. This arises when you’ve received payment before earning the income.

For example, if a customer pays you in advance for a year’s services, you may need to spread the income across the period in which you provide those services.

These adjustments follow the same general principle as accruals and prepayments: income should be recognised in the appropriate accounting period.

How do accruals and prepayments affect your accounts?

If you prepare accounts using the accruals basis, these adjustments affect both your profit and loss account and your balance sheet.

Your profit and loss account shows the income you’ve earned and the expenses you’ve incurred during the period, rather than simply recording money received and paid.

Your balance sheet includes amounts relating to those adjustments.

For example:

• Accrued expenses generally appear as liabilities because they represent amounts your business owes.
• Prepayments appear as assets because you’ve paid for goods or services that will benefit future periods.
• Accrued income generally appears as an asset because you’ve earned income that hasn’t yet been invoiced or received.
• Deferred income generally appears as a liability because you’ve been paid for goods or services you haven’t yet provided.

If you’d like a refresher on how these figures fit into your accounts, our guide to reading a balance sheet explains the main components.

By recognising income and expenditure in the correct periods, you get a more meaningful picture of your business’s financial performance.

This can also help when you’re comparing profits from one year to another or using management accounts to make decisions.

Do you need to calculate accruals and prepayments?

That depends on the accounting method your business uses.

If you run a limited company

Limited companies must prepare their statutory accounts using the accruals basis. The cash basis isn’t available to them for calculating taxable trading profits.

This means you’ll usually need to make appropriate accruals and prepayments adjustments when preparing your annual accounts.

The precise treatment depends on the applicable accounting standards and whether an adjustment is material to your accounts.

If you’re a sole trader or partnership

Different rules may apply if you are a sole trader or belong to a partnership.

Since the 2024/25 tax year, the cash basis has been the default method for calculating taxable trading profits for eligible sole traders and partnerships.

Under the cash basis, you generally record income when you receive payment and expenses when you pay them. You don’t normally need to make the accruals and prepayments adjustments described in this article.

However, some businesses aren’t eligible for cash basis accounting. Others may choose to use traditional accounting instead, particularly if they need more detailed financial information.

You can find out more about the differences in HMRC’s guidance on cash basis accounting.

If you’re unsure which method applies to your business, it’s worth checking before preparing your accounts or calculating your taxable profits.

Getting your accruals and prepayments right

Accruals and prepayments might seem like small accounting adjustments, but they can have a significant effect on your reported profits.

If you overlook an expense that hasn’t yet been invoiced, your profits could appear higher than they really are. Equally, if you charge the full cost of an annual insurance policy to the wrong period, you could understate profit in one year and overstate it in the next.

Keeping accurate records throughout the year will make these adjustments easier. It’s also worth reviewing regular expenses, outstanding bills and payments covering future periods before your financial year ends.

At THP Chartered Accountants, we can help you prepare accurate annual accounts and understand what the figures mean for your business.

Whether you need help with year-end adjustments or ongoing financial reporting, our friendly team is here to help.

Find out more about our annual accounts services or get in touch to discuss your requirements.