According to the law, expenses and income must be recorded in the financial year to which they are economically attributable. The logical consequence is that there are invoices that sometimes relate to several periods and therefore have to be split up, or more precisely delimited, according to the real allocation. We’ll therefore show in this paper how you a Prepaid are creating, verbuchst them and what to look for it.
Accruals and deferrals – definition
To understand exactly how accruals work, you first need to know the fundamentals of bookkeeping , which make accruals necessary in the first place. We will therefore take a closer look at this first.
What is deferred income?
In some cases, invoice amounts cannot be assigned to just one fiscal year, but must be distributed proportionally over two periods . Regardless of whether you receive an invoice or send it, the deferred income represents a posting that ensures that expenses and income can be allocated to the appropriate period and thus in accordance with the legal requirements.
According to wholevehicles.com, a delimitation is therefore always necessary when expenditure and expenditure or income and income fall in different periods.
What do you need deferred income for?
It is one of the principles of proper accounting to split expenses and income according to the periods to which they can be allocated. In this way, the accruals and deferrals are, to put it simply, an adjustment posting that ensures this correct allocation. The easiest way to understand the need for accruals is an example.
Imagine paying for insurance for a year in advance in December. Of course, you cannot leave the entire effort in December, but have to book it proportionally for the following year.
Depending on whether you delimit expenses or income, the term active deferred income (ARA) or deferred income (PRA) is used.
When is accrual and deferral necessary?
Since accruals and deferrals are a very sensitive issue, there are very precise guidelines that must be adhered to. Therefore, you have to assign every expense and income to the period . So there is no minimum amount, rather it must always be possible to determine the success of the period. It is therefore important that you ensure through ARA and PRA that the amounts are distributed accordingly and can then be correctly incorporated into the annual financial statements .
However, the principle of materiality also applies in accounting. You can neglect very minimal amounts with regard to the delimitation, whereby you should always consider and evaluate them individually. Better to book too much than too little accrual than to get into trouble with the tax office.
Graphic representation – ARA and PRA
For a better understanding, we have graphed the options for deferred income below, whereby we also speak of transitory and anticipatory items .
You can clearly see the process here. First you check when the payment was made, then whether you have to make the payment or receive it and this will determine which booking will be necessary accordingly.
How does prepaid expenses work?
Now that you know the theoretical process of accruals, the question naturally arises as to how you can now book accruals in practice.
Post accruals and deferrals
When posting , it depends individually on whether it is a claim or a liability and which part of the payment is attributable to which period. Depending on the situation, you make the corresponding booking.
Posting – active accruals and deferrals
Let’s first look at active accruals and deferrals . This is always necessary if you pay amounts before the balance sheet date that affect expenses in the following year. This means, for example, that you pay insurance for one year in advance, but the amount applies in part to this fiscal year and partly to the next. It is also conceivable that there are cases where the next financial year is only affected.
Accordingly, you now have to post active accruals and deferrals. First you determine how much of the total amount is due to which period, for example 10 out of 12 months are due to the next financial year. So you have to delimit this part of the total amount.
Corresponding bookings now follow:
- 1. Booking: booking the payment, i.e.: insurance premiums | Bank
- 2. Posting: ARA (sometimes also called “Active RAP” for “prepaid expenses”) | Insurance premiums
- 3. Booking: You have to cancel the booking accordingly in the following year, so an offsetting booking is made: Insurance contributions | Active RAP
So you first record the business case, then assign the delimitation and then resolve it again. This mechanism then assigns all amounts to the correct periods.
Posting – deferred income
In principle, passive accruals and deferrals are identical, just the other way round. Here we have the case that a payment was received before the balance sheet date. So the income has already taken place, although the income will not take place until the next financial year. This happens, for example, if you charge a customer a usage fee for a year in advance or rent is paid to you one year in advance.
The posting then takes place in several steps:
- 1. Booking: First you create the demarcation, eg: usage fees | Passive RAP
- 2. Posting: In the following financial year you dissolve the accrual with the offsetting entry, i.e.: Passive RAP | Usage fees
The invoice is posted as usual with the total amount. So you see, both active and passive delimitation are very easy to post, you can’t really go wrong here. It is important that you divide the amount correctly.
In order to avoid confusion with regard to the terms used, we now also explain two frequently used technical terms. A distinction is made between deferred accruals and accruals.
From transient demarcation we speak when revenue or expenses are taken before the balance sheet date but are recognized after the deadline. Anticipatory delimitation, on the other hand, means that income or expenses have not yet been paid, but must be added to the financial year to be closed.
Balance sheet date
The balance sheet date is the decisive date for drawing up the balance sheet . On this day you have to check whether you have entered all amounts in the appropriate period. The balance sheet date is by no means always December 31. – Unfortunately, this is a widespread misconception. Companies can also have different fiscal years that do not coincide with the calendar year.
It is important that you deal with the accrual allocation in good time and that you generally start planning and drawing up your balance sheet at an early stage.
Active accruals and deferrals
In summary, it can be said that accruals are a relatively simple process in your accounting. You have to make sure that you calculate the amounts to be divided correctly and then make the corresponding booking and counter-booking. All in all, little can go wrong here, although you must of course not forget to post the opposite booking in the following year.
The main difference between active and passive demarcation lies in whether you have received money or have to pay yourself and in whether a payment only affects later periods or exactly the other way round, the current period is already affected but payment will only be made later. In the end, it’s always about creating your accounting on an accrual basis so that you can always close your financial year correctly.
Transitional and anticipatory costs
As mentioned briefly before, transitory and anticipatory costs are also often mentioned. The difference is very simple, because it de facto coincides with the distinction between active and passive accruals and deferrals.
Transitory costs exist if the payments are made before the balance sheet date, but only then affect the income statement. On the other hand, it is anticipatory if income or expenses have not yet been realized, but these must already be included in the current financial year.
Recommendations for action in practice
The fewer delimitations are necessary, the less work you have in your accounting. In practice, however, there is also the principle of materiality, which means that you can neglect minimally deviating amounts with regard to the delimitation. At the same time, you are on the safe side if it is better to post an accrual more often than to have problems later during an audit by the tax office.
So always keep in mind that you have to be honest about your result . Postings that create the wrong picture of your financial situation are extremely problematic and must be avoided at all costs. Especially when the amounts are not minimal, you have to make delimitations very precisely.
A distinction is made between active deferred income (ARA or also called active PRA) and passive deferred income (called PRA or passive PRA). Accruals and accruals may sound complicated at first, but in practice they are very simple postings that can be carried out quickly. It is important that the amounts are proportionally divided correctly and that you think of both bookings, i.e. also do not forget the counter-booking in the following year.
The basic principle is simply that your financial statements must reflect real facts. This also means that payments are allocated to those periods in which they are actually to be recorded appropriately. Due to prepayments, for example for insurance, license fees or rent, it is obvious that these payments have to be distributed accordingly to the respective periods concerned.
While you can expect a certain goodwill with minimal amounts, you should, conversely, be more precise with higher amounts and ensure that all delimitations are correct.