Accruals and prepayments are two of the most common adjustments in monthly management accounts, and they are also two of the most misunderstood. Both exist for the same reason: to make sure a cost appears in the accounting period it relates to, rather than simply in the period when the invoice arrived or the payment left the bank.

An accrual brings a cost into the accounts where the goods or services have already been received but the invoice has not yet come in. A prepayment does the opposite, moving part of a cost into a future period where the business has paid in advance. Neither adjustment changes the bank balance. What they change is the profit figure reported for a given month — sometimes by a material amount.

That is why looking only at bank transactions does not always give a clear picture of how a business actually performed. This post sets out how both adjustments work, what they affect, and what a reasonable approach to calculating and maintaining them looks like.

An accrual records a cost that belongs in the current period where the supplier invoice has not yet been received or entered into the accounts. Suppose a business receives £4,000 of consultancy work during March, but the supplier does not issue the invoice until April. If the March management accounts ignore that cost, March profit may look £4,000 higher than the underlying position. Recognising an accrual brings that £4,000 into March, where it belongs.

A prepayment applies where the business has paid for something before the full cost belongs in the current period. If a company pays £12,000 for 12 months of insurance in January, charging the full amount to January would put the entire annual cost into one month. The business may instead recognise £1,000 each month and carry the remaining balance forward as a prepayment on the balance sheet.

Both adjustments are concerned with the same thing: putting a cost into the month it actually relates to, regardless of when the invoice was raised or the payment was made.

An accrual normally increases the costs shown in a period and therefore reduces reported profit. Consider a set of management accounts that shows revenue of £80,000, recorded costs of £55,000, and a profit before accruals of £25,000. If the business then identifies £6,000 of subcontractor work completed during the month but not yet invoiced, recognising the accrual changes the picture: costs rise to £61,000 and profit falls to £19,000. No money has left the bank for that £6,000, but the cost belongs in the period being reviewed.

Prepayments work in the other direction. If a company pays £24,000 in April for a 12-month software licence, charging the full amount to April would make that month look considerably less profitable than the underlying trading position warrants. If the licence covers 12 months, the accounting treatment may instead recognise £2,000 each month. The remaining balance stays on the balance sheet and is released over the following months. The bank still shows a £24,000 payment; the monthly profit and loss account reflects only the cost attributable to that month.

These are not cosmetic changes. When accruals and prepayments are applied consistently, they give a materially more accurate picture of what the business earned and spent during a given period.

Management accounts are used to understand how a business performed during a particular month or quarter. If costs move between periods simply because invoices arrive early or late, monthly comparisons can become difficult to interpret.

Without timing adjustments, one month may contain 12 months of insurance, a supplier invoice may arrive after the work was completed, quarterly professional fees may land all at once, or an annual software subscription may create a large one-off cost. Those movements do not necessarily mean business performance changed sharply. They may simply reflect when invoices were raised or payments were made.

Payment timing can also move independently of the period the income or cost relates to. Research from the Office of the Small Business Commissioner found that over 1.5 million businesses, representing 28% of businesses, are affected by late payments each year. That is one reason management accounts should not rely solely on when invoices are paid or cash reaches the bank.

Keeping underlying records current makes those timing differences easier to identify. HMRC's final evaluation of Making Tax Digital for VAT found that 48% of businesses kept their VAT records up to date continuously after MTD, compared with 38% before it. Regular bookkeeping does not remove the need for accruals and prepayments, but it does make it easier to see which costs still need adjusting before the management accounts are reviewed.

The specific adjustments required will depend on the business, but certain cost types come up regularly.

Common accruals

• Subcontractor costs
• Professional fees
• Utilities
• Commissions and bonuses
• Freight or delivery costs
• Interest
• Services received before the supplier invoice arrives

For example, if £10,000 of subcontractor work was completed in March but the invoice arrives in April, the March management accounts may need to reflect that cost.

Common prepayments

• Insurance
• Annual software licences
• Subscriptions
• Rent
• Maintenance agreements
• Service contracts
• Professional memberships

Suppose a £6,000 annual subscription starts on 1 October. Only part of the payment relates to October; the rest relates to future months and should be carried forward accordingly.

The approach should be proportionate. A £40 annual subscription will make very little difference to monthly performance; a £40,000 annual contract could make a significant one. Deciding which adjustments to make, and how to calculate them, is a matter of materiality and consistency rather than applying every possible adjustment regardless of size.

An accrual does not always have an exact supplier invoice behind it, because the invoice may not yet exist. The figure still needs a reasonable basis. That could come from agreed supplier rates, contracts, purchase orders, timesheets, previous invoices, units delivered, or project records. If a subcontractor completed 80 hours at an agreed rate of £75 per hour, there is a clear starting point for a £6,000 accrual.

Prepayments should be equally well supported. If £12,000 has been paid for a 12-month insurance policy, the business should know when the policy starts and ends and how much should be released each month. The calculation should be simple enough to follow and tied back to the underlying records.

Crucially, accruals and prepayments should not be set up and then forgotten. If £5,000 was accrued in March and the supplier then sends a £5,200 invoice in April, the earlier adjustment needs to be cleared and the £200 difference dealt with. Without that step, the business could record both the accrual and the later invoice as separate costs.

The same applies to prepayments. If £12,000 was prepaid for 12 months of insurance, the balance should reduce as each month's cost is recognised. After three months, £3,000 may have been charged to the profit and loss account and £9,000 may remain as a prepayment on the balance sheet.

A monthly review should check which accruals are still required, which invoices have arrived, whether estimates need revising, which prepayments should be released, and whether any old balances can be cleared. Because these adjustments affect reported profit rather than cash timing, management accounts are best reviewed alongside cash flow rather than treating the two as the same thing.