Learning objectives
By the end of this chapter, you should be able to:
- Explain what accruals, prepayments, accrued income, and deferred income are, and why they matter at the reporting date.
- Calculate and post period-end adjustments so that income and expenses are recognised in the correct period.
- Explain how each adjustment affects profit and the statement of financial position (assets and liabilities).
- Apply a consistent period-end routine, including reversals where they are used.
- Identify typical cut-off errors and correct them using appropriate journal entries.
Overview & key concepts
Period-end cut-off: what the statements must capture
At the reporting date, the accounts should reflect what has been used and what has been earned up to that date. Cash is often a poor guide because payments and receipts may occur before or after the related activity.
A reliable way to spot period-end adjustments is to take each major expense and income line and ask:
- Does it relate to this accounting period? (Has it been consumed/earned by the reporting date?)
- Has it already been recorded in the ledger? (Not just paid/received.)
- Has cash moved? (Helpful context, but not the deciding factor.)
Use the answers to diagnose the adjustment:
- Relates to this period but missing from the ledger → accrual (expense) or accrued income (income).
- Recorded in the ledger but partly relates to a future period → prepayment (expense) or deferred income (income).
These adjustments prevent profit being distorted by timing and ensure the statement of financial position includes the related rights (assets) and obligations (liabilities) at the reporting date.
Overview definitions (exam-focused)
Accruals (expenses payable)
Meaning: An expense belongs to the current period, but it has not been recorded by the reporting date (often because the invoice has not arrived yet or has not been entered, or because an amount is estimated).
Effect:
- Expense increases (reduces profit)
- Liability increases (amount owed)
Examiner-style clarification (invoice received): If the supplier invoice has already been processed in the ledger, the credit is normally sitting in trade payables, so no additional accrual is needed. An accrual is used when the expense relates to the period but is not yet recorded at the reporting date (whether invoiced or not).
Prepayments
Meaning: Cash has been paid and recorded, but the benefit will be received partly or wholly after the reporting date.
Effect:
- Expense decreases (increases profit)
- Asset increases (future benefit)
Accrued income (income receivable)
Meaning: Income has been earned by the reporting date but has not yet been received and may not yet have been invoiced. The adjustment recognises the income earned and the related right to receive it.
Effect:
- Income increases (increases profit)
- Asset increases (amount due)
Deferred income (income received in advance)
Meaning: Cash has been received, but the income has not yet been earned at the reporting date because goods/services are still owed.
Key link (earning, not cash): Deferred income arises because performance is still outstanding at the reporting date — cash received does not determine when income is recognised.
Effect:
- Income decreases (reduces profit)
- Liability increases (obligation to provide future goods/services)
Core theory and frameworks
Debit/credit anchor (quick reference)
- Expenses: debit increases, credit decreases
- Income: credit increases, debit decreases
- Assets: debit increases, credit decreases
- Liabilities: credit increases, debit decreases
Accruals (expense not yet recorded)
Period-end entry:
- Dr Expense
- Cr Accrued expenses (liability)
Prepayments (expense recorded but not yet consumed)
Two bookkeeping routes exist; both end with the same year-end balances.
If payment was posted to expense during the year (common in questions):
- Dr Prepayments (asset)
- Cr Expense
If payment was posted to a prepayment asset during the year:
- Dr Expense
- Cr Prepayments (asset)
Accrued income (income earned but not yet recorded/received)
Period-end entry:
- Dr Accrued income (asset)
- Cr Income
Deferred income (income recorded/received but not yet earned)
Two bookkeeping routes exist; both end with the same year-end balances.
If receipt was posted to income during the year (common in questions):
- Dr Income
- Cr Deferred income (liability)
If receipt was posted to deferred income during the year:
- Dr Deferred income (liability)
- Cr Income
Presentation note (typical classification)
Accrued income and prepayments are typically presented as current assets, and accrued expenses and deferred income as current liabilities, unless the timing clearly extends beyond 12 months.
Time apportionment (even pattern)
Where costs or income accrue evenly:
- Monthly amount = total ÷ months covered
- Period portion = monthly amount × months in the period
- Balance becomes prepayment (expense) or deferred income (income).
Reversing entries
A reversing entry cancels certain year-end accrual-type adjustments at the start of the next period to simplify routine posting.
Important exam note: Reversals are rarely required in exam answers unless the question asks for them or the narrative indicates they are used in the bookkeeping system.
Worked example
Narrative scenario
ABC Ltd provides services and prepares accounts to 31 December.
Assume that, unless stated otherwise:
- Cash payments are recorded to the relevant expense account when paid.
- Cash receipts are recorded to the relevant income account when received.
- Outstanding items at year end have not yet been recorded.
The following items require period-end adjustment:
- On 1 October, ABC Ltd paid £3,600 for insurance covering 12 months.
- A December utilities bill for £500 has been received but is unpaid at 31 December.
- On 1 December, ABC Ltd received £12,000 for a 6-month service contract running from 1 December.
- Interest income of £300 has been earned by 31 December but not yet received.
- Rent of £2,000 per month for December is unpaid at 31 December.
- On 31 December, ABC Ltd paid a £1,200 subscription covering the next 12 months (January to December).
- Training fees received total £9,000, of which £2,400 relates to courses delivered next year.
- Commission income of £1,850 has been earned by 31 December but not yet received.
- An electricity invoice for £620 relating to December is unpaid at 31 December.
- A customer paid £5,000 in advance for a project that starts next year.
Required
- Calculate and record the required adjustments for accruals and prepayments.
- Calculate and record the required adjustments for accrued income and deferred income.
- Show the impact of the adjustments on profit and on the statement of financial position.
- Identify and correct cut-off issues within the transactions.
Solution
Step 1: Diagnose each item before journalling
For each item ask: (a) Does it relate to this year? (b) Is it already recorded? (c) Has cash moved?
Then choose the adjustment:
- Missing cost for this year → accrual
- Cost recorded but future benefit remains → prepayment
- Missing income for this year → accrued income
- Income recorded/received but not earned yet → deferred income
A) Prepayments (assets)
1) Insurance prepayment
- Total paid: £3,600 for 12 months from 1 October
- Monthly cost: £3,600 ÷ 12 = £300
- Months used in current year (Oct–Dec): 3
- Expense for the year: 3 × £300 = £900
- Prepayment at 31 December: £3,600 − £900 = £2,700
Adjusting entry (remove unexpired portion from expense):
- Dr Prepayments £2,700
- Cr Insurance expense £2,700
2) Subscription prepayment
Payment made on 31 December covering the next 12 months (all future benefit).
- Prepayment at 31 December: £1,200
- Expense for the year: £0
Adjusting entry:
- Dr Prepayments £1,200
- Cr Subscription expense £1,200
B) Accruals (liabilities)
3) Utilities accrual (invoice received, not recorded)
Utilities bill for December £500 received but unpaid and not recorded.
Adjusting entry:
- Dr Utilities expense £500
- Cr Accrued expenses £500
Examiner-style clarification: If that invoice had already been entered during December, the credit would normally be in trade payables already (Dr utilities expense / Cr trade payables). In that case, you would not create a second liability via an accrual.
4) Rent accrual
Unpaid rent for December: £2,000
Adjusting entry:
- Dr Rent expense £2,000
- Cr Accrued expenses £2,000
5) Electricity accrual
Unpaid December electricity invoice: £620
Adjusting entry:
- Dr Electricity expense £620
- Cr Accrued expenses £620
Cut-off note: This scenario includes both “utilities” and “electricity”. Treat them as separate December costs unless evidence suggests duplication.
C) Accrued income (assets)
6) Interest accrued
Interest earned by year end not yet received: £300
Adjusting entry:
- Dr Accrued income £300
- Cr Interest income £300
7) Commission accrued
Commission earned by year end not yet received: £1,850
Adjusting entry:
- Dr Accrued income £1,850
- Cr Commission income £1,850
D) Deferred income (liabilities)
8) Service contract income received in advance
Cash received 1 December: £12,000 for 6 months from 1 December.
- Monthly earning: £12,000 ÷ 6 = £2,000
- Earned by 31 December: 1 month = £2,000
- Unearned at 31 December: £12,000 − £2,000 = £10,000
Because receipts were credited to income during the year, defer the unearned portion:
Adjusting entry:
- Dr Service income £10,000
- Cr Deferred income £10,000
9) Training fees received in advance
Total training fees received: £9,000 Portion relating to next year: £2,400 (unearned at year end)
Adjusting entry:
- Dr Training fee income £2,400
- Cr Deferred income £2,400
10) Customer advance for next-year project
Advance received for a project starting next year: £5,000 (entirely unearned)
Adjusting entry:
- Dr Project income £5,000
- Cr Deferred income £5,000
What happens next year (timing reversal concept)
These adjustments reverse through normal activity in the following period:
- Prepayment becomes expense as the benefit is consumed (expense increases next year).
- Accrual becomes a recorded payable settlement when the invoice is processed and/or cash is paid (liability reduces next year).
- Accrued income becomes cash received or an invoice raised and settled (asset reduces next year).
- Deferred income becomes income as services are delivered (liability reduces; income increases next year).
Impact on profit and statement of financial position
1) Impact on profit for the year (net effect)
Increases profit (reduce expenses / increase income):
- Insurance: reduce expense by £2,700
- Subscription: reduce expense by £1,200
- Interest accrued: add income £300
- Commission accrued: add income £1,850
Total increase = £2,700 + £1,200 + £300 + £1,850 = £6,050
Decreases profit (add expenses / reduce income):
- Utilities accrual: add expense £500
- Rent accrual: add expense £2,000
- Electricity accrual: add expense £620
- Service contract deferred: reduce income £10,000
- Training fees deferred: reduce income £2,400
- Customer advance deferred: reduce income £5,000
Total decrease = £500 + £2,000 + £620 + £10,000 + £2,400 + £5,000 = £20,520
Net impact on profit: £6,050 − £20,520 = £14,470 decrease
2) Impact on statement of financial position at 31 December
Assets increase (typically current):
- Prepayments: £2,700 + £1,200 = £3,900
- Accrued income: £300 + £1,850 = £2,150
Total asset increase = £6,050
Liabilities increase (typically current):
- Accrued expenses: £500 + £2,000 + £620 = £3,120
- Deferred income: £10,000 + £2,400 + £5,000 = £17,400
Total liability increase = £20,520
Net decrease in equity (via profit effect): £20,520 − £6,050 = £14,470, matching the reduction in profit.
Common pitfalls and misunderstandings
- Accrual vs trade payables confusion: If an invoice has already been posted, the liability is in trade payables already; do not create a second liability using an accrual.
- Treating cash received as proof of income earned: income is recognised when earned; unearned receipts belong in deferred income.
- Wrong direction journals: remember the debit/credit anchor for assets, liabilities, income and expenses.
- Partial periods: always calculate the portion up to (and after) the reporting date carefully.
- Double counting similar expenses: if two items look like they might overlap (e.g., utilities vs electricity), confirm whether they are separate costs or duplicates before adjusting.
Summary
Period-end adjustments correct timing differences between cash flow and economic activity:
- Accruals (expense payable): Dr expense / Cr accrued expenses (liability)
- Prepayments: Dr prepayment (asset) / Cr expense
- Accrued income: Dr accrued income (asset) / Cr income
- Deferred income: Dr income / Cr deferred income (liability)
These entries ensure profit reflects what is earned and consumed in the period, and the statement of financial position shows the related assets and liabilities at the reporting date.
FAQ
What is the difference between accruals and prepayments?
Accruals recognise missing costs for the period (liability created). Prepayments remove costs already recorded that belong to a future period (asset created).
How does deferred income affect the financial statements?
Deferred income is a liability because the entity has not yet earned the income at the reporting date. It reduces current-period income so profit is not overstated.
Are reversing entries required?
Reversals are optional and depend on the system described. They are rarely needed in exam answers unless specifically requested or clearly implied by the scenario.
How do you apportion amounts over time?
Where the pattern is even, calculate a periodic rate (e.g., monthly) and allocate based on the portion relating to the current period. The balance becomes a prepayment (expense) or deferred income (income).
What are typical cut-off errors?
Common errors include recognising income too early (cash received but not earned), omitting unpaid expenses for the period, and failing to split payments/receipts that cover more than one accounting period.
Glossary
Accrual (expense payable) A period-end adjustment recognising an expense relating to the period that has not yet been recorded by the reporting date. Creates a liability.
Prepayment An amount paid and recorded, where the related benefit will be received after the reporting date. The unexpired portion is shown as an asset.
Accrued income (income receivable) Income earned by the reporting date that has not yet been received (and may not yet be invoiced). Shown as an asset.
Deferred income (income received in advance) Cash received for goods/services that will be provided after the reporting date. The unearned portion is shown as a liability.
Adjusting entry A period-end journal entry that corrects income/expense timing and recognises any related asset or liability.
Reversing entry An optional entry at the start of the next period that cancels certain accrual-type adjustments, used to simplify routine posting.
Cut-off Recording transactions in the correct reporting period so income and expenses reflect the activity up to the reporting date.