chapter 4 accruals and prepayments

7/27/2019 Chapter 4 Accruals and Prepayments

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CHAPTER 4

Accruals and prepayments1 Accruals and prepayments

1.1 The accruals concept

The aim of accruals and prepayments is to ensure that the correct amount of income andexpenses is included in the income statement and that any amounts outstanding or paid inadvance are recognised and shown in the balance sheet.

The accruals concept (also called the matching convention) states that income and expensesshould be matched together and dealt with in the income statement for the period to which theyrelate 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 ended31 December 20X8 in respect of the following expenses.

(a) Telephone charges: $800 paid for 1 January 20X8 to 30 November 20X8; quarter ended28 February 20X9 was $300.

(b) Insurance: paid annually in advance on 1 April. Charge to 31 March 20X8 was $3,000and charge to 31 March 20X9 was $4,000.

1.3 Solution

(a) Telephone charges

Step 1

Establish the period you are accounting for.

1 January 20X8 to 31 December 20X8

If it helps, draw a time line.

Step 2

Establish the period the expense covers.

1 January 20X8 to 30 November 20X8 $800

1 December 20X8 to 28 February 20X9 $300

Step 3

Using a time line again

1 January 20X8 31 December 20X8


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$

1 January 20X8 to 30 November 20X8 800

December 20X8 charges (= one third of the charge for the threemonths to 28 February 20X9)

100

___

Total telephone charge for the year 900

___

(b) Insurance charges

$

(i) Insurance paid last year relating to our period

1 January 20X8 to 31 March 20X8 = 3 months

Therefore12

3 $3,000 was last years prepayment 750

(ii) Insurance paid in the year for period 1 April 20X8 to 31March 20X9

4,000

(iii) Insurance paid which covers next year

1 January 20X9 to 31 March 20X9 = 3 months

Therefore12

3 $4,000 is the prepayment (1,000)

_____

Total insurance charge for the year 3,750

_____

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

31 December 20X8Our year end

30 November 20X8Last date covered for

telephone charge

28 February 20X91 January 20X8

1 January 20X8 1 April 20X8

Insurance paid$4,000

31 December 20X8

Our year end

31 March 20X9

Insurance paid to thisdate


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

2 Accrued expenses

2.1 Introduction

We have seen above the general principle of accruals and prepayments. We shall now look ataccruals in more detail.

An accrual is an item of expense that has been incurred during the accounting period but hasnot been paid at the period end.

In order to ensure that all expenses incurred in a period have been included in the incomestatement, the accountant must ensure that the expense accounts include not only those itemsthat 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 madepayments for the rent of a shop as follows.

$31 March (for quarter to 31 March 20X8) 3,000

29 June (for quarter to 30 June 20X8) 3,000

2 October (for quarter to 30 September 20X8) 3,000

The final payment due on 31 December 20X8 for the quarter to that date was not paid until2 January 20X9.

Required

Prepare the ledger account for shop rent for the year ended 31 December 20X8.

2.3 Solution

1 Enter all cash paid

Shop rent

20X8 $ $

31 Mar Cash 3,000

29 Jun Cash 3,000

2 Oct Cash 3,000

2 What period are we accounting for? 1 January 20X8 to 31 December 20X8.

3 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 Rent expense Income statement $3,000

Credit Accruals Balance sheet $3,000

4 Record the accrual as the carried forward amount in the ledger account.

Shop rent


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20X8 $ 20X8 $

31 Mar Cash 3,000

29 Jun Cash 3,000 31 Dec Incomestatement

12,000

2 Oct Cash 3,000

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) 3,000

28 March (for quarter to 31 March 20X9) 3,000

28 June (for quarter to 30 June 20X9) 3,000

4 October (for quarter to 30 September 20X9) 3,000

23 December (for quarter to 31 December 20X9) 3,000

Required

Write up the ledger account for shop rent for the year ended 31 December 20X9.

2.5 Solution

1 Bring forward the balance from last year.Shop rent

20X9 $ 20X9 $

2 Jan Cash 3,000 1 Jan Accrual b/d 3,000

When the payment made on 2 January 20X9 (relating to the last quarter of 20X8) isrecorded, the brought forward accrual has the effect of cancelling out the payment, soleaving 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 $ 20X9 $

2 Jan Cash 3,000 1 Jan Accrual b/d 3,000

28 Mar Cash 3,000

28 Jun Cash 3,000 31 Dec Incomestatement

12,000

4 Oct Cash 3,000

23 Dec 3,000


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Cash ______ ______

15,000

______

15,000

______

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


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3 Prepaid expenses

3.1 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 periodbut which relates to a future accounting period.

As well as ensuring that all the expenses in the period appear in the income statement, theaccountant must also ensure that items of expense relating to future periods, but which havealready 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) 700

28 March (for six months to 30 September 20X8) 1,500

2 October (for six months to 31 March 20X9) 1,500

Required

Calculate the insurance expense for the year ended 31 December 20X8 and write up theinsurance ledger account.

3.3 Solution

1 Enter all cash paid

Shop insurance

20X8 $ 20X8 $

1 Jan Cash 700

28 Mar Cash 1,500

2 Oct Cash 1,500

2 What period are we accounting for? 1 January 20X8 to 31 December 20X8

3 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 removedfrom the expense total and shown as a prepayment in the balance sheet.

The double entry is as follows.

Debit Prepayments Balance sheet $750Credit Insurance expense Income statement $750

The amount of the prepayment is calculated as $1,500

3/6.


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4 Record the prepayment as the carried forward amount in the ledger account.

Shop insurance20X8 $ 20X8 $

1 Jan Cash 700 31 Dec Income statement 2,95028 Mar Cash 1,5002 Oct Cash 1,500 31 Dec Prepayment c/d 750

_____ _____

3,700_____

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 hisinsurance in two instalments of $1,500 in April and October of this year.

Required

Write up the insurance ledger account for 20X9.

3.5 Solution

1 Bring forward the balance from last year.

Shop insurance

20X9 $ 20X9 $

1 Jan Prepayment b/d 750

This time the brought forward figure brings in the first quarters charges for insurance tocomplete the charge for the year.

2 Enter all cash paid.

Shop insurance

20X9 $ 20X9 $

1 Jan Prepayment b/d 750

31 Dec Income statement 3,000

1 Apr Cash 1,500

1 Oct Cash 1,500

_____

31 Dec Prepayment c/d

(3/6 $1,500)

750_____

3,750_____

3,750_____

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

4 Mixtures of prepayments and accruals

4.1 Introduction


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Some expenses will have a combination of accruals and prepayments. The most commonexample 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 asfollows.

$

Quarterly rental payable in advance on 1 February, 1 May, 1 August and 1November each year 60Calls paid in arrears for previous three months

1 February 20X8 120

1 May 20X8 90

1 August 20X8 145

1 November 20X8 120

1 February 20X9 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

$

Paid in the year 4 $60 240

Brought forward from 20X73

1 $60 20

Carried forward to 20X93

1 $60 (20)___

Charge for the year 240___

1 November20X7

1 February20X8

1 May20X8

1 August

20X8

1 November

20X8

1 February

20X9

1 January20X8

31 December20X8

$60 $60 $60 $60 $60


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(b) Call charges, paid in arrears

$

Paid in the year (120 + 90 + 145 + 120) 475

Relating to last year3

2 120 (80)

Outstanding for this year3

2 135 90___

Charge for the year 485___

3 Write up the ledger account.

Telephone

20X8 $ 20X8 $

1 Jan Rental prepaid b/d 20 1 Jan Calls accrued b/d 80

1 Feb Rental 60

Calls 120

1 May Rental 60

Calls 90

1 Aug Rental 60

Calls 145

1 Nov Rental 60

Calls 120

31 Dec Income statement (240 +485)

725

31 Dec Calls accruedc/d

90____

31 Dec Rental prepaid c/d 20____

825____

825____

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 Revenues

5.1 Introduction

Accruals and prepayments may also apply to items of miscellaneous incomepaid in advanceor arrears.

Basically the same principles apply as for expenses but the entries are the opposite way round.

1 November20X7

1 February20X8

1 May20X8

1 August20X8

1 November20X8

1 February20X9

1 January20X8

31 December20X8

$120 $90 $145 $120 $135


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5.2 Example

John Smith receives rental income quarterly in advance of $1,000. The payments are due on 1March, 1 June, 1 September and 1 December each year.

Required

Write up the rent receivable account for 20X8.

5.3 Solution

1 Enter all cash received

Rental income

20X8 $ 20X8 $

1 Mar Cash 1,000

1 Jun Cash 1,000

1 Sept Cash 1,000

1 Dec Cash 1,000

2 What period are we accounting for? 1 January 20X8 to 31 December 20X8

3 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 takenout at the end of the year.

Rent received in advance

Two months to bring in rentreceived last year on 1 Dec 20X7 3

2 $1,000 = $667

Two months to take out rentreceived for next year on 1 Dec 20X8 3

2 $1,000 = $667

4 Write up the ledger account.

Rental income

20X8 $ 20X8 $

31 Dec Income statement 4,000 1 Jan Early receipt b/d 667

1 Mar Cash 1,000

1 Jun Cash 1,000

1 Sep Cash 1,000

1 Dec Cash 1,000

31 Dec Early receipt c/d 667_____ _____4,667

_____4,667

_____

6 Balance sheet presentation

1 December20X7

1 March20X8

1 June20X8

1 September20X8

1 December20X8

28 February

20X9

1 January20X8

31 December20X8

Paid


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6.1 Introduction

A balance on an income or expense account represents a prepayment or an accrual and willbe shown in the balance sheet with all other account balances. They appear under theheadings 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 X

Receivables X

Less: allowance for doubtful debts (X)___

X

Prepayments X

Cash at bank X

Cash in hand X___

X

___Current liabilities

Payables X

Accruals and deferred income X___

X___

7 SummaryAn 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 adjustmentbe:

A Accrual $300

B Accrual $600

C Prepayment $600

D Prepayment $300

2 Pays its telephone bill for the quarter ended 31 December 20X0 - $150. Will theadjustment be:

A Accrual $150

B Prepayment $150

C Cash payment $100

D No adjustment


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3 Pays rates on 1 February and 1 August in advance - $1,200 each. Will the adjustmentbe:

A Accrual $800

B Prepayment $400

C Accrual $400

D Prepayment $800

chapter 4 accruals and prepayments

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