Why bother with accruals and prepayments?

There are plenty of aspects of finance which just don't float a business owner's boat – top of the list is probably accruals and prepayments.

Surely it’s simpler just to cash account?? At least your cash flow is easier to monitor, right?

Well, not really…

But before we get into the nitty gritty, what exactly are accruals and prepayments anyway?

Accruals:

Imagine you received a service from a contractor in the month, but you haven’t been invoiced for it (nor paid it).? Ideally you should record that cost now, not later when you pay. You’d do this by creating an accrual.? To recognize this cost, your accountant will do what’s called a manual journal. (You can also accrue income but I won’t be covering this today).

Prepayments:

Think of this as when you pay for things in advance.? For example, if you pay your office rent six months upfront.? You shouldn’t just put the whole amount into one month’s expense.? Instead it should be spread out equally over 6 months. Again, this will be adjusted by your accountant using a manual journal.

So why bother?

If you don't use accruals and prepayments, you'll find it very hard to keep a track of your profits (which means making decisions becomes very tricky!).

One month, your profits will appear to have dropped through the floor, and yet the next month, you'll think you’re swimming in cash. And you’ll have no idea why.

Here are some simple example to show you why accruals and prepayments are such a good idea:

Scenario 1: Your business without accruals

You hire a freelancer for a big project that’s taking months to complete.? They aren’t very good at invoicing on time, and so some months you don’t have any invoices and others you have two.

If the monthly revenue from the client is ￡10,000 and the freelancer’s monthly invoice is ￡8,000, then, using accrual accounting you would always show a profit of ￡2,000 per month.

Without accrual accounting, depending on when the invoices are received the profit could fluctuate from ￡10,000 to a loss of -￡6,000 each month.

For example. Let’s say in July no invoices are received from the freelancer.? Without accrual adjustments:

• July Profit Without Adjustments:

o?? Revenue: ￡10,000

o?? Expenses: 0 (No invoices from freelancer)

o?? Profit: ￡10,000

Looking at just the profit number you might think, great, I’ve got more money than I was expecting and you decide to go and spend it.? But what you hadn’t realized is the following month things don’t look so rosy:

• August Profit Without Adjustments:

o?? Revenue: ￡10,000

o?? Expenses: ￡16,000 (two invoices from freelancer)

o?? Loss: (￡6,000)

And because you don’t have a cash-flow forecast monitoring your cash position, you’re now in a lot of bother because you went and spent what you thought were surplus profits!

Scenario 2: Your business with accruals

If you had made an accrual in the first month, then instead, both July and August would have show a much more sensible profit number:

• July and August Profit With Adjustments:

o?? Revenue: ￡10,000

o?? Expenses: ￡8,000 (accrual accounting)

o?? Profit: ￡2,000

The method of implementing accruals and prepayments means you avoid the stress of roller coaster profits. It means you'll be able to take more informed decisions and crucially, will have more accurate information for stakeholders or potential investors.

Implementing this isn't tricky, but it does take some considered thought and action. A Fractional Finance Director might be the perfect way to get this going in your business. Drop me a message to find out exactly how.

And stay tuned, next week I’ll give an example of where you should use prepayments.