What Is the Difference Between Accruals and Prepayments?
While accruals and prepayments are both used to ensure that financial statements reflect accurate income and expense totals, they represent two very different aspects of accounting.
Accruals are liabilities that are recorded in the general ledger at month’s end to account for expenses that have occurred during a specific accounting period that have not yet been paid.
For example, wages and salaries are often accrued at the end of one accounting period because they won’t be paid until the following accounting period.
Prepaid expenses are expenses that are paid in advance.
For example, you have a contract with a local cleaning service to clean your office at a rate of $13,000 annually, with the cost dropping to $12,000 if you pay for the entire year upfront.
You take advantage of the discount and pay the entire amount in January.
However, you don’t want to show a $12,000 expense for January, so you’ll record it as a prepaid expense, and expense a set amount each month until the prepayment has been used in its entirety.
The initial journal entry would be for the total amount:
January 31, 2023
|Prepaid Expense||$12,000|| |
Next, you’ll want to expense $1,000 a month for the next twelve months for cleaning expenses, until the entire $12,000 has been expensed.
Starting in January and for each month in 2023, you will complete the following journal entry:
January 31, 2023
|Cleaning Expense||$1,000|| |
|Prepaid Expense|| ||$1,000|
This entry records the $1,000 expense each month while reducing the prepaid expense account balance each month as well.
Prepaid expenses are often used for paying for yearly contracts such as insurance, subscriptions, memberships, and even rent.
How Can Software Help Report on Accruals More Quickly and Accurately?
Managing accruals manually can be overwhelming. Not only will you have to remember to manually enter an accrual at month-end, but you’ll also have to remember to reverse that accrual the following month.
Forgetting to do so can seriously impact the accuracy of your financial statements.
Using an automated accounting software application, posting accruals is a much simpler process, with most of today’s accounting software applications automatically reversing accrual entries the following accounting period.
Using accounting software also makes it easier to pinpoint missing invoices, allowing you to follow up with vendors and suppliers promptly, eliminating the need to accrue accounts payable.