Chapter 4 Accruals and Prepayments

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The key takeaways are that accruals and prepayments are used to match expenses and revenues to the correct accounting period, and involve adjusting account balances for items received or paid in advance. Timelines are a useful tool for calculating accruals and prepayment amounts.

The accruals concept, also called the matching principle, states that revenues and expenses should be matched and reported in the income statement for the period to which they relate, regardless of when cash is received or paid. This ensures expenses are reported in the periods that benefit from those expenses.

An accrued expense is an expense that has been incurred during the accounting period but has not yet been paid by the end of the period. Accrued expenses are reported as current liabilities on the balance sheet.

CHAPTER 4

Accruals and prepayments


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1.1

Accruals and prepayments


The accruals concept

The aim of accruals and prepayments is to ensure that the correct amount of income and expenses is included in the income statement and that any amounts outstanding or paid in advance are recognised and shown in the balance sheet. The accruals concept (also called the matching convention) states that income and expenses should be matched together and dealt with in the income statement for the period to which they relate regardless of the period in which the cash was actually received or paid. 1.2 Example

Calculate or estimate how much should be charged in the income statement in the year ended 31 December 20X8 in respect of the following expenses. (a) (b) Telephone charges: $800 paid for 1 January 20X8 to 30 November 20X8; quarter ended 28 February 20X9 was $300. Insurance: paid annually in advance on 1 April. Charge to 31 March 20X8 was $3,000 and charge to 31 March 20X9 was $4,000. Solution Telephone charges

1.3 (a)

Step 1 Establish the period you are accounting for. 1 January 20X8 to 31 December 20X8 If it helps, draw a time line.

1 January 20X8

31 December 20X8

Step 2 Establish the period the expense covers.


1 January 20X8 1 December 20X8 to to 30 November 20X8 28 February 20X9 $800 $300

Step 3 Using a time line again

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1 January 20X8

30 November 20X8 Last date covered for telephone charge 31 December 20X8 Our year end

28 February 20X9

$ 1 January 20X8 to 30 November 20X8 December 20X8 charges (= one third of the charge for the three months to 28 February 20X9) Total telephone charge for the year 800 100 ___ 900 ___

(b)

Insurance charges

1 January 20X8

1 April 20X8 Insurance paid $4,000

31 December 20X8 31 March 20X9 Our year end Insurance paid to this date

$ (i) Insurance paid last year relating to our period 1 January 20X8 to 31 March 20X8 = 3 months Therefore (ii) (iii)
3 12

$3,000 was last years prepayment

750 4,000

Insurance paid in the year for period 1 April 20X8 to 31 March 20X9 Insurance paid which covers next year 1 January 20X9 to 31 March 20X9 = 3 months Therefore
3 12

$4,000 is the prepayment

(1,000) _____ 3,750 _____

Total insurance charge for the year

The amount of cash paid in a year cannot be altered and has to be recorded regardless of the period it covers. Accruals and prepayments are used to make any necessary adjustments.

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Chapter 4 Accruals and prepayments

Use time lines, your fingers or whatever method suits you in order to calculate the number of months to be adjusted.

2
2.1

Accrued expenses
Introduction

We have seen above the general principle of accruals and prepayments. We shall now look at accruals in more detail. An accrual is an item of expense that has been incurred during the accounting period but has not been paid at the period end. In order to ensure that all expenses incurred in a period have been included in the income statement, the accountant must ensure that the expense accounts include not only those items that have been paid for during the period but also any outstanding amounts. 2.2 Example

John Smiths business has a year end of 31 December 20X8. During the year John made payments for the rent of a shop as follows.
$ 31 March (for quarter to 31 March 20X8) 29 June (for quarter to 30 June 20X8) 2 October (for quarter to 30 September 20X8) 3,000 3,000 3,000

The final payment due on 31 December 20X8 for the quarter to that date was not paid until 2 January 20X9. Required Prepare the ledger account for shop rent for the year ended 31 December 20X8. 2.3 1 Solution Enter all cash paid
Shop rent 20X8 31 Mar 29 Jun 2 Oct Cash Cash Cash $ 3,000 3,000 3,000 $

2 3

What period are we accounting for? 1 January 20X8 to 31 December 20X8. What period is covered by payments? 1 January 20X8 to 30 September 20X8. Therefore the last quarter 1 October 20X8 to 31 December 20X8 must be added to the expense and showed as owing in the balance sheet. The double entry is as follows.
Debit Credit Rent expense Accruals Income statement Balance sheet $3,000 $3,000

Record the accrual as the carried forward amount in the ledger account.
Shop rent

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20X8 31 Mar 29 Jun 2 Oct Cash Cash Cash

$ 3,000 3,000 3,000

20X8

31 Dec statement

Income

12,000

31 Dec

Accrual c/d

3,000 ______ 12,000 ______

______ 12,000 ______

In practice there will usually be an opening balance on the account. 2.4 Example

Following on from John Smith into his next year, 31 December 20X9. Payments in the year were as follows.
$ 2 January (for quarter to 31 December 20X8) 28 March (for quarter to 31 March 20X9) 28 June (for quarter to 30 June 20X9) 4 October (for quarter to 30 September 20X9) 23 December (for quarter to 31 December 20X9) 3,000 3,000 3,000 3,000 3,000

Required Write up the ledger account for shop rent for the year ended 31 December 20X9. 2.5 1 Solution Bring forward the balance from last year.
Shop rent 20X9 2 Jan Cash $ 3,000 20X9 1 Jan Accrual b/d $ 3,000

When the payment made on 2 January 20X9 (relating to the last quarter of 20X8) is recorded, the brought forward accrual has the effect of cancelling out the payment, so leaving the account at nil. This means that going forward only amounts relating to 20X9 will be included. 2 Enter all cash paid.
Shop rent 20X9 2 Jan 28 Mar 28 Jun 4 Oct 23 Dec Cash Cash Cash Cash $ 3,000 3,000 3,000 3,000 3,000 31 Dec statement Income 12,000 20X9 1 Jan Accrual b/d $ 3,000

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Chapter 4 Accruals and prepayments


______ 15,000 ______ ______ 15,000 ______

Cash

This year all four quarters rent has been paid in the year and so there is no accrual to be made at the end of the year.

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3
3.1

Prepaid expenses
Introduction

It is now time to look at prepayments in more detail. A prepayment is an item of expense that has been paid during the current accounting period but which relates to a future accounting period. As well as ensuring that all the expenses in the period appear in the income statement, the accountant must also ensure that items of expense relating to future periods, but which have already been paid for, are not shown as expenses of the current period. 3.2 Example

John Smith pays insurance on his shop in advance. His payments for 20X8 were as follows.
$ 1 January (for three months to 31 March 20X8) 28 March (for six months to 30 September 20X8) 2 October (for six months to 31 March 20X9) 700 1,500 1,500

Required Calculate the insurance expense for the year ended 31 December 20X8 and write up the insurance ledger account. 3.3 1 Solution Enter all cash paid
20X8 1 Jan 28 Mar 2 Oct $ 700 1,500 1,500 Shop insurance 20X8 $

Cash Cash Cash

2 3

What period are we accounting for? 1 January 20X8 to 31 December 20X8 What period is covered by payments? 1 January 20X8 to 31 March 20X9 Therefore 1 January 20X9 to 31 March 20X9 relates to next year and should be removed from the expense total and shown as a prepayment in the balance sheet. The double entry is as follows.
Debit Credit Prepayments Insurance expense Balance sheet Income statement $750 $750

The amount of the prepayment is calculated as $1,500 3/6.

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Chapter 4 Accruals and prepayments

4
20X8 1 Jan 28 Mar 2 Oct

Record the prepayment as the carried forward amount in the ledger account.
$ Cash Cash Cash 700 1,500 1,500 _____ 3,700 _____ Shop insurance 20X8 31 Dec 31 Dec Income statement Prepayment c/d $ 2,950 750 _____ 3,700 _____

In practice there will often be a brought forward balance on the account. 3.4 Example

Following on from John Smith into his next year to 31 December 20X9, John pays his insurance in two instalments of $1,500 in April and October of this year. Required Write up the insurance ledger account for 20X9. 3.5 1 Solution Bring forward the balance from last year.
Shop insurance 20X9 1 Jan Prepayment b/d $ 750 20X9 $

This time the brought forward figure brings in the first quarters charges for insurance to complete the charge for the year. 2 Enter all cash paid.
Shop insurance 20X9 31 Dec 1 Apr 1 Oct Cash Cash 1,500 1,500 31 Dec Prepayment c/d (3/6 $1,500) 750 _____ 3,750 _____ Income statement

20X9 1 Jan

Prepayment b/d

$ 750

$ 3,000

_____ 3,750 _____

Again a prepayment has been made for three months into the next year which will be carried forward as an asset in the balance sheet.

4
4.1

Mixtures of prepayments and accruals


Introduction 51

Some expenses will have a combination of accruals and prepayments. The most common example is the telephone bill: line rental is paid in advance and call charges in arrears. 4.2 Example

John Smiths telephone bills for the period 1 January 20X8 to 31 December 20X8 are as follows.
$ Quarterly rental payable in advance on 1 February, 1 May, 1 August and 1 November each year Calls paid in arrears for previous three months 1 February 20X8 1 May 20X8 1 August 20X8 1 November 20X8 1 February 20X9 60 120 90 145 120 135

Required Write up the telephone expense ledger account for the year ending 31 December 20X8. 4.3 Solution

Draw two time lines, one for rental and one for calls. (a) Rental, paid in advance

$60

1 January 20X8

$60

$60

$60

$60

31 December 20X8

1 November 20X7

1 February 20X8

1 May 20X8

1 August 20X8

1 November 20X8

1 February 20X9

Paid in the year Brought forward from 20X7 Carried forward to 20X9 Charge for the year

4 $60
1 3 1 3

$60 $60

$ 240 20 (20) ___ 240 ___

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Chapter 4 Accruals and prepayments

(b)

Call charges, paid in arrears

1 January 20X8

$120

$90

$145

$120

31 December 20X8

$135

1 November 20X7

1 February 20X8

1 May 20X8

1 August 20X8

1 November 20X8

1 February 20X9

Paid in the year Relating to last year Outstanding for this year Charge for the year

(120 + 90 + 145 + 120)


2 3 2 3

120 135

$ 475 (80) 90 ___ 485 ___

3
20X8 1 Jan 1 Feb

Write up the ledger account.


Telephone $ 20X8 20 1 Jan 60 120 60 90 60 145 60 120 31 Dec 485) 90 31 Dec ____ 825 ____ $ 80

1 May 1 Aug 1 Nov

Rental prepaid b/d Rental Calls Rental Calls Rental Calls Rental Calls

Calls accrued b/d

Income

statement

(240

725 20 ____ 825 ____

31 Dec c/d

Calls

accrued

Rental prepaid c/d

As your confidence grows you will be able to skip straight to the ledger account. However, always show the working in brackets (eg 1/3 $60).

5
5.1

Revenues
Introduction

Accruals and prepayments may also apply to items of miscellaneous income paid in advance or arrears. Basically the same principles apply as for expenses but the entries are the opposite way round.

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5.2

Example

John Smith receives rental income quarterly in advance of $1,000. The payments are due on 1 March, 1 June, 1 September and 1 December each year. Required Write up the rent receivable account for 20X8. 5.3 1
20X8

Solution Enter all cash received


$ Rental income 20X8 1 Mar 1 Jun 1 Sept 1 Dec $ 1,000 1,000 1,000 1,000

Cash Cash Cash Cash

2 3

What period are we accounting for? 1 January 20X8 to 31 December 20X8 What period is covered by amounts received? 1 March 20X8 to 28 February 20X9

Therefore two months need to be brought in at the beginning of the year and two months taken out at the end of the year. Rent received in advance

1 January 20X8

31 December 20X8

Paid

1 December 20X7

1 March 20X8

1 June 20X8

1 September 20X8

1 December 20X8

28 February 20X9

Two months to bring in rent received last year on 1 Dec 20X7 Two months to take out rent received for next year on 1 Dec 20X8

2 3
2 3

$1,000 $1,000

= $667 = $667

Write up the ledger account.


20X8 31 Dec Rental income $ 20X8 4,000 1 Jan 1 Mar 1 Jun 1 Sep 1 Dec 667 _____ 4,667 _____ $ 667 1,000 1,000 1,000 1,000 _____ 4,667 _____

Income statement

Early receipt b/d Cash Cash Cash Cash

31 Dec

Early receipt c/d

6
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Balance sheet presentation

Chapter 4 Accruals and prepayments

6.1

Introduction

A balance on an income or expense account represents a prepayment or an accrual and will be shown in the balance sheet with all other account balances. They appear under the headings Current assets and Current liabilities as they tend to be short-term in nature. 6.2 Example

An extract from a balance sheet is shown below.


$ Current assets Inventories Receivables Less: allowance for doubtful debts $ X X (X) ___ X X X X ___ X ___ X X ___ X ___

Prepayments Cash at bank Cash in hand

Current liabilities Payables Accruals and deferred income

Summary

An accrual is an expense that has been incurred but has not yet been paid at the period end. Accrued amounts are shown in the balance sheet as current liabilities. A prepayment is an item of expense that has been paid but which relates to a future period. Prepaid amounts are shown in the balance sheet as current assets.

Multiple choice questions (The answers are in the final chapter of this book)
A business has a year end of 31 March 20X1 and makes the following payments. 1 Pays $1,500 for insurance from 1 July 20X0 for 15 months. Will the year end adjustment be: A B C D 2 Accrual $300 Accrual $600 Prepayment $600 Prepayment $300 Will the

Pays its telephone bill for the quarter ended 31 December 20X0 - $150. adjustment be: A B C D Accrual $150 Prepayment $150 Cash payment $100 No adjustment

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Pays rates on 1 February and 1 August in advance - $1,200 each. Will the adjustment be: A B C D Accrual $800 Prepayment $400 Accrual $400 Prepayment $800

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