While managing your accounting processes and ledgers, you often have to struggle through the confusing terms of accruals and prepayments. Besides, you also hear about the accruals and prepayments to manage your expenses and revenues.
These confusing accounting terms can lead to errors in reporting the financial statements or you can skip any entry due to incorrect ledger placement of invoices or account receivables. As a result, the managers have to take special care while assigning and managing both accrual and prepayments entries in their ledgers.
These two concepts are very different from a cash-based accounting system in which you pay your current expenses and receive income in cash and you add them directly to your bookkeeping record.
Let’s learn how accruals and prepayments are different from each other with the help of simple examples!
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Accruals in Accounting
Accruals are a part of expenses or income incurred without any payment made. In other words, you have earned income, but it has not been paid to you. So, this type of income earned is considered accruals.
Similarly, you have purchased some items for your business without making any final payments. This kind of expense has occurred and payment has not yet been made. So, income earned and expenses incurred for which payment has been deferred are known as accruals in accounting.
One benefit of the accruals system is that your business can grasp the full future liabilities and what cash it will most probably receive in the future.
Example of Accruals
Many organisations make many purchases and earn income from different sources. However, it is not possible to make all the cash payments on the spot. Sometimes, these payments are deferred as accruals in the accounting system.
For example, accounts payables, accounts receivables, tax liabilities, and accrued interest rates. An example is a bonus for employees. Let’s suppose a company paid a bonus to an employee in the year 2021 that will be paid in the year 2022. So, a bonus is an expense incurred without any payment made. So, it will be added as a credit in the liability account and as a debit in the expense account in 2019. When the bonus will be paid, this bonus entry will be credited to the expense account and debited in the liability account.
Prepayments in Accounting
Unlike accruals in which payments are deferred, the prepayments make payments for expenses yet not incurred. In other words, it is advance payments for the upcoming or expected expenses in the future.
These prepayments are mostly used for debt or loan obligations and operating or non-operating expenses. Many organisations prefer to make advance payments for recurring expenditures like rent, wages, interest rate,s and lines of credit.
Example of Prepayments
Examples of prepayments include advance payments for goods and services before their arrival and ahead of time. Moreover, these payments refer to the advance payment of the company’s loans and debt liabilities partially or completely.
Sometimes, companies have to make prepayment penalties for the early settlement of their debts. A prepayment penalty is charged by the lender, typically around 2% of the outstanding balance, for making all the debt payments ahead of the due date.
In sum, accruals and prepayments are more than payments as they provide more information about the future expenses and income of a company. Accruals are payments made after the expenses have been incurred like the electricity bills. These bills have been incurred but have not been yet paid.
On the other hand, prepayments are the advance payments of the debts and loans ahead of the schedule. However, some lenders charge a prepayment penalty for making early payments. So, accruals and prepayments are crucial to understanding the expenses and incomes, invoices, and other accounting terms.
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Disclaimer: The information about Accruals and Prepayments provided in this article including text, images, and graphics is general in nature and does not intend to disregard any professional advice.