Chapter 6: Accruals and prepayments

Chapter learning objectives

Upon completion of this chapter you will be able to:

• explain the need for adjustments for accruals and prepayments in preparing financial statements
• illustrate the process of adjusting for accruals and prepayments in preparing financial statements.

1 Accruals basis of accounting

The accruals basis of accounting means that to calculate theprofit for the period, we must include all the income and expenditurerelating to the period, whether or not the cash has been received orpaid or an invoice received.

Profit is therefore:

Accruals concept

The accruals concept is identified as an important accountingconcept by IAS 1 Presentation of Financial Statements. The concept isthat income and expenses should be matched together and dealt with inthe income statement for the period to which they relate, regardless ofthe period in which the cash was actually received or paid. Thereforeall of the expenses involved in making the sales for a period should bematched with the sales income and dealt with in the period in which thesales themselves are accounted for.

Sales revenue

The sales revenue for an accounting period is included in theincome statement when the sales are made. This means that, when a saleis made on credit, it is recognised in the income statement when theagreement is made and the invoice is sent to the customer rather thanwaiting until the cash for the sale is received. This is done by settingup a receivable in the statement of financial position for the amountof cash that is due from the sale (debit receivables and credit salesrevenue).

Purchases

Similarly purchases are matched to the period in which they weremade by accounting for all credit purchases when they took place andsetting up a payable in the statement of financial position for theamount due (debit purchases and credit payables).

Cost of sales

The major cost involved in making sales in a period is the actualcost of the goods that are being sold. As we saw in a previous chapter,we need to adjust for opening and closing inventory to ensure that thesales made in the period are matched with the actual costs of thosegoods. Any goods unsold are carried forward to the next period so thatthey are accounted for when they are actually sold.

Expenses

The expenses of the period that the business has incurred inmaking its sales, such as rent, electricity and telephone, must also bematched with the sales for the period. This means that the actualexpense incurred in the period should be included in the incomestatement rather than simply the amount of the expense that has beenpaid in cash.

 2 Accrued expenditure

 An accrual arises where expenses of the business, relating to the year, have not been paid by the year end.

In this case, it is necessary to record the extra expense relevantto the year and create a corresponding statement of financial positionliability (called an accrual):

An accrual will therefore reduce profit in the income statement.

Illustration 1 – Accrued expenditure

Accrued expenditure

A business’ electricity charges amount to $12,000 pa. In the yearto 31 December 20X5, $9,000 has been paid. The electricity for thefinal quarter is paid in January 20X6.

What year-end accrual is required and what is the electricity expense for the year?

Show the relevant entries in the ledger accounts.

Solution

Solution

• The total expense charged to the income statement in respect of electricity should be $12,000.
• The year-end accrual is the $3,000 expense that has not been paid in cash.
• The double entry required is:
• Dr Electricity expense $3,000
• Cr Accruals $3,000

Ledger accounts and accrued expenses

Method 1: know the accrual

Method 2: know the income statement charge

Test your understanding 1

John Simnel’s business has an accounting year end of 31December 20X1. He rents factory space at a rental cost of $5,000 perquarter, payable in arrears.

During the year to 31 December 20X1 his cash payments of rent have been as follows:

• 31 March (for the quarter to 31 March 20X1) $5,000
• 29 June (for the quarter to 30 June 20X1) $5,000
• 2 October (for the quarter to 30 September 20X1) $5,000

The final payment due on 31 December 20X1 for the quarter to that date was not paid until 4 January 20X2.

Show the ledger accounts required to record the above transactions.

Accrued expenditure will reduce profit in the Income statement andwill also create a current liability on the Statement of financialposition.

For example, if we were to put through an accrual of $500 for telephone expenses. The double entry would be:

Dr Telephone expenses $500

Cr Accruals $500

The additional telephone expense would reduce profits by $500. Theadditional accrual would increase our current liabilities by $500.

 3 Prepaid expenditure

 A prepayment arises where some of the following year’s expenses have been paid in the current year.

In this case, it is necessary to remove that part of the expensewhich is not relevant to this year and create a corresponding statementof financial position asset (called a prepayment):

A prepayment will therefore increase profit in the income statement.

Illustration 2 – Prepaid expenditure

The annual insurance charge for a business is $24,000 pa. $30,000was paid on 1 January 20X5 in respect of future insurance charges.

What is the year-end prepayment and what is the insurance expense for the year?

Show the relevant entries in the ledger accounts.

Solution to recording accrued expenditure

Solution

• The total expense charged to the income statement in respect of insurance should be $24,000.
• The year-end prepayment is the $6,000 that has been paid in respect of 20X6.

The double entry required is:

Dr Prepayment $6,000

Cr Insurance expense $6,000

Test your understanding 2

Tubby Wadlow pays the rental expense on his market stall inadvance. He starts business on 1 January 20X5 and on that date pays$1,200 in respect of the first quarter’s rent. During his first yearof trade he also pays the following amounts:

• 3 March (in respect of the quarter ended 30 June) $1,200
• 14 June (in respect of the quarter ended 30 September) $1,200
• 25 September (in respect of the quarter $1,400 ended 31 December)
• 13 December (in respect of the first quarter of 20X6) $1,400

Show these transactions in the rental expense account.

Prepaid expenditure increases profit on the Income statement andalso creates a current asset to be included on the Statement offinancial position.

For example, if we were to put a prepayment of $1,000 in our financial statements for insurance, the double entry would be:

Dr Prepayments $1,000

Cr Insurance expense $1,000

The prepayments side would increase our current assets by the$1,000. The insurance expense would decrease by the $1,000, and henceincrease our overall profits.

Proforma expense T account

Test your understanding 3

On 1 January 20X5, Willy Mossop owed $2,000 in respect of theprevious year’s electricity. Willy made the following payments duringthe year ended 31 December 20X5:

• 6 February $2,800
• 8 May $3,000
• 5 August $2,750
• 10 November $3,100

At 31 December 20X5, Willy calculated that he owed $1,800 in respect of electricity for the last part of the year.

What is the electricity charge to the income statement?

A $1,800

B $11,450

C $11,650

D $13,450

 4 Accrued income

 Accrued income arises where income has been earned in the accounting period but has not yet been received.

In this case, it is necessary to record the extra income in theincome statement and create a corresponding asset in the statement offinancial position (called accrued income):

Dr Accrued income (SFP) X

Cr Income (IS) X

Accrued income creates an additional current asset on our Statementof financial position. It also creates additional income on our Incomestatement, and hence this will increase overall profits.

Illustration 3 – Accrued income

Accrued income

A business earns bank interest income of $300 per month. $3,000bank interest income has been received in the year to 31 December 20X5.

What is the year-end asset and what is the bank interest income for the year?

Show the relevant entries in the ledger accounts.

Solution to recording prepaid expenditure

Solution

• The total amount credited to the income statement in respect of interest should be $3,600 (12 x $300).
• The year-end accrued income asset is the $600 that has not yet been received.

The double entry required is:

Dr Accrued income (SFP) $600

Cr Bank interest income (IS) $600

 5 Prepaid income

 Prepaid income arises where income has been received in the accounting period but which relates to the next accounting period.

In this case, it is necessary to remove the income not relating tothe year from the income statement and create a corresponding liabilityin the statement of financial position (called prepaid income):

Illustration 4 – Prepaid income

Prepaid income

A business rents out a property at an income of $4,000 per month. $64,000 has been received in the year ended 31 December 20X5.

What is the year-end liability and what is the rental income for the year?

Show the relevant entries in the ledger accounts.

Solution

Solution

• The total amount credited to the income statement in respect of rent should be $48,000 (12 x $4,000).
• The year-end prepaid income liability is the $16,000 ($64,000 – $48,000) that has been received in respect of next year.

The double entry required is:

Dr Rental income $16,000

Cr Prepaid income (SFP) $16,000

Prepaid income reduces income on the Income statement and hencereduces overall profits too. It also creates a current liability on ourStatement of financial position.

Proforma income T account

Test your understanding 4

Accrued and prepaid income

Libby Farquar receives income from two rental units as follows:

What is Libby’s rental income in the income statement for the year ended 31 December 20X5?

A $5,400

B $8,700

C $14,000

D $14,100

Chapter summary

Test your understanding answers

Test your understanding 1

Test your understanding 2

Test your understanding 3

The correct answer is B

Test your understanding 4

The correct answer is D

Total income: $8,700 + $5,400 = $14,100

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