A common question asked is “What are accruals and prepayments for?”, lets forget the technical wording and try to explain in simple language.
Let look at something simple for the accruals as it is far to easy to muddle and confuse the explanation by being to complicated with accounting jargon, we will look at the household budget and a project for the decoration of three bedrooms.
The house is owned by a young working couple on a limited budget, it is a new build property and the walls are painted throughout, there are some settlement cracks that need filling and a couple of coats of paint are needed to refresh the bedrooms.
The couple will supply the materials and use a local tradesman who they will pay by invoice at the end of the project, the decorator will have access to one of the bedrooms each week for three weeks.
We will calculate the project accruals at the end of each week, now we need to look at what we would accrue.
Our local tradesman agrees to carry out the work for $300 a room, decorate one room a week so our couple can empty and move the rooms over the weekends, and has agreed to invoice at the end of the project.
The decorator gave our couple a list of materials required for the project and the couple spent $180 on the paint and materials to decorate the three rooms.
What we accrue
The materials cost $180 and were paid for on the couples credit card so they have a liability to pay their credit card bill, this liability we will not need to accrue for in full each week, but we will accrue for any materials the decorator has opened or consumed.
If we look at the picture the decorator has not opened three of the paint tins or used the roller and brush, they have the credit card bill to come in later, so the unused materials could be returned and the credit card refunded.
We have a project budget of $1080 this will change from a budget to a liability and accrual over the three weeks of the project.
At the end of the first week the decorator has opened or consumed $70 of the materials and the decorators wages come to $300, so the couple have an accrual and liability at this stage of $370, that would be all they would have to pay if they stopped the project and returned unused materials.
At the end of the second week the decorator has opened or consumed $140 of the materials and the decorators wages come to $600, so the couple have an accrual and liability at this stage of $740, that would be all they would have to pay if they stopped the project and returned unused materials.
At the end of the third week the decorator has opened or consumed $160 of the materials and the decorators wages come to $900, so the couple have an accrual and liability at this stage of $1060, that would be all they would have to pay if they stopped the project and returned unused materials.
How nice, the couple have the project finished on time and $20 under budget, if they return the un-opened materials.
Now we have a basic overview of accruals we can see that they are financial liabilities for goods or services the company has consumed but has not been invoiced for, lets look at another example of something a company would want to accrue, if our business collects upfront payments from customers, then this is deferred revenue and is also a liability until our company provides the goods or services the remaining liability and should be accrued in the management reports.
If we want to look at our management accounts to see if we are on our trading target we could calculate out liabilities that are not yet invoiced the remaining balances for prepaid overheads, deferred revenue and expected costs “as at” a date which are the accruals, we would have the “Sales to Date” values which would include any deferred revenue, and deduct any actual costs (Invoiced), plus any accruals for expected costs, deferred revenue and overheads.
So at period six we might have revenue of $1,300,000 but a true revenue of $1,100,000 as $200,000 is deferred revenue, we take our revenue to date of $1,300,000 and deduct, invoiced costs of $800,000, deferred revenue of $200,000 and $50,000 of un-invoiced “expected costs” leaving a sales margin of $250,000.
As we can see accruals are financial liabilities for goods or services a company has consumed but have not been invoiced, so prepayments are the opposite financial accounting for goods or services a company has not consumed and have already been invoiced.
Prepayments are an asset as they might be able to be refunded if the goods or services are not required or consumed, these can be a number of things, prepaid insurances, rates or service charges, a full years insurance for 12 months we would calculate half as a prepayment at the end of period six, that is a calculated prepayment value for any unused months.