I was trying to tick off some quick jobs on my to-do list today and thought I might as well get my Self Assessment Tax Return completed (this was my first underestimation – it was not a quick job). All I needed to do first was to add in the prepayments and accruals to my accounts which weren’t going to be many…..this was my second underestimation as I discovered all of the things I had forgotten I had purchased over the year. So I thought I’d procrastinate on dealing with that and instead explain to you all what exactly accruals and prepayments are.

The first thing to be aware of is that these only apply to people using accrual accounting. So if you are using cash basis accounting then this isn’t the post for you. Go and make yourself a drink and enjoy 5 minutes of peace. For the rest of you, let’s get started.

Accruals and prepayments are used to make sure that the purchases you make in your business are included in the correct financial year. Depending on how frequently you need to see up to date information in your business will determine how often you use them. For most small businesses I’d recommend just doing them at your year end. As they can be a little tricky to wrap your head around, I’ll try my best to explain them as simply as possible.

Prepayments

Prepayments are where you have paid in advance for something. The best example of a typical prepayment is when you pay for a year long subscription to something and that year crosses over the end of your financial year. So say your year end is 31st March 2023, but on 1st January 2023 you bought a subscription to some software for a year. That means that in your financial year 1st April 2022 to 31st March 2023, you’ve only actually used 3 months of that subscription. The other 9 months will be used in your next financial year.

To show this accurately in your finances you will need to split the total cost of the subscription into 12 months and only include the 3 months in your 2022 – 2023 financial year. The cost of the remaining 9 months will go into your next financial year. So say the subscription costs £120, splitting that into 12 months gives £120 / 12 = £10. The 3 months cost that you need to include is £10 x 3 = £30. The remaining £90 goes into the next financial year.

Doing this means you are accurately showing the cost of the software that you have used in that financial year. You wouldn’t be overstating your expenses and giving an unrealistic view of how your business has performed that year.

Accruals

Accruals are where you know that you have something coming up that you need to pay for but haven’t been billed for it yet. The best example of this is a monthly phone bill that you receive the bill for after the end of the month. Using the same dates as before, your financial year ended on 31st March 2023 but you haven’t received the phone bill for March yet. You know what the amount is as it is the same every month so you just need to include that amount in your 2022 – 2023 accounts. If you wait until you receive the bill, and it is dated after your year end, you would have to include it in the next financial year, which would imply that the service you received was not in the previous year ergo inaccurate accounts.

Why do we bother doing this at all? What does it matter as long as all the expenses are included somewhere? Well, basically, it’s for accuracy and so that you can clearly see how your business has performed. If you’re not putting your expenses into the correct financial year it could look like you have performed better or worse than you actually have. That could lead to you having to pay more or less tax than you should be doing, and nobody wants that! It also means you’re not viewing your correct financial data which could lead to you making decisions that you wouldn’t have made if you had the right information. So it might be a pain to do, but you’ll feel much better knowing everything is accurate!

P.S. You’ll be pleased to know that I did manage to get all my prepayments and accruals put in and I have now completed my Self Assessment Tax Return only 1 month after the return window opened (whoop whoop mini celebration to me!).