ACCA Financial Reporting (F7) Practice Exam

What distinguishes an accrual from a prepayment?

1. Accruals are future payments; prepayments are past expenses

2. Accruals are incurred expenses not yet paid; prepayments are paid in advance

3. Accruals relate to cash receipts; prepayments relate to cash outflows

4. Accruals are recognized at reporting period end; prepayments at year start

The correct answer is: Accruals are incurred expenses not yet paid; prepayments are paid in advance

The distinction between an accrual and a prepayment is best encapsulated in the understanding that accruals represent expenses that have been incurred but not yet settled with cash at the reporting date, while prepayments pertain to cash that has been paid in advance for goods or services to be received in the future. Accruals adhere to the matching principle in accounting, ensuring that expenses are recognized in the period in which they are incurred, which reflects a true and fair view of a company's financial position. For instance, if a company has received a service in December but will not pay for it until January, the expense must still be recognized in December's financial statements as an accrual. On the other hand, prepayments are recorded as assets when cash is paid for goods or services that will be received in subsequent accounting periods. This might include rent paid in advance or insurance premiums that cover future periods. The expense isn’t recognized until the benefit of that payment is realized in the future. Therefore, the correct answer reflects these definitions, clarifying the nature of accruals as incurred expenses yet to be settled and prepayments as payments made ahead of time for future expenditures.