Accruals and Prepayments
The statement of profit or loss must show the income and expenses that belong to the period — not simply the cash received and paid in it. A payment in advance for next period is a prepayment (a current asset); an expense used but not yet paid or billed is an accrual (a current liability). The same idea applies to income received in advance and income earned but not yet received. This chapter works four examples for expenses over two years, adds the income side, and sums up every journal entry.
1 Introduction
In the previous chapter we went through the steps for recording transactions through to the preparation of the financial statements.
However, there are four types of adjustments that the accountant will normally have to make when preparing the financial statements to deal with items that will not have been recorded on a day by day basis by the bookkeeper.
These adjustments are: accruals and prepayments; depreciation; irrecoverable debts and allowances; and inventory.
We will deal with these adjustments separately – accruals and prepayments in this chapter, and the others in the subsequent chapters.
Accruals and prepayments apply the accruals (or matching) concept: income and expenses are recognised in the period in which they are earned or incurred, not in the period in which the cash happens to be received or paid. Chapter 23 returns to the concept.
2 Prepayments
A prepayment is a payment in advance. For example, it is normal to pay car insurance for a whole year at the beginning of the year. If our year-end were to occur half-way through the insurance period, then we would only have actually used half of the insurance. The other half of the payment would be paid in advance, and in theory – were we to close down – would be repayable to the company. In practice, it would not be repaid because we would stay in business and use the rest of the insurance in the following period. For this reason we do not show the amount of the over-payment as a receivable, but show it separately in the Statement of Financial Position as a prepayment.
The bookkeeper will have recorded the whole amount of the payment. However, if again we had paid for a year but only used half a year so far, then it would be wrong to show the full payment as an expense in the Statement of Profit or Loss.
We will illustrate the accounting treatment for prepayments by means of an example. At the end of this chapter we will summarise all the entries needed.
Karen started business on 1 January 2000.
During the year to 31 December 2000, she made the following payments for insurance:
Date paid | Amount | Period covered |
5 January 2000 | $800 | for the 6 months to 30 June 2000 |
15 June 2000 | $2,000 | for the 12 months to 30 June 2001 |
(a) Show extracts from the Statement of Profit or Loss and Statement of Financial Position
(b) Write up the t-account for Insurance for the year to 31 December 2000
(c) Close off the t-account
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3 Accruals
An accrued expense (or accrual) is the name we give to an amount owing for which we have not received an invoice. For example, suppose we receive electricity bills every 3 months, at the end of March, June, September, and December. If our accounting year end occurs at the end of July, then we will owe for the electricity used in July, even though we will not receive an invoice until after the end of September. The bookkeeper will only have entered the bills received, and it is therefore up to the accountant to make an adjustment for the amount still owed.
Again, we will illustrate the entries by an example and summarise the rules at the end of the chapter.
Amit started business on 1 April 2000, and during the year to 31 March 2001 he made the following payments in respect of telephone:
Date paid | Amount | Period covered |
18 July 2000 | $500 | for the 3 months to 30 June 2000 |
22 October 2000 | $600 | for the 3 months to 30 September 2000 |
14 January 2001 | $750 | for the 3 months to 31 December 2000 |
As at 31 March 2001, Amit estimated that $950 was owing for the 3 months to 31 March 2001. He had however not received a bill from the telephone company.
(a) Show extracts from the Statement of Profit or Loss and Statement of Financial Position.
(b) Write up the t-account for Telephone for the year to 31 March 2001
(c) Close off the account
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4 Subsequent accounting periods
In both of the two previous examples, we were dealing with the first year of trading. At the end of the year we left balances on the t-accounts for Prepayments (in the case of Karen) and on Accruals (in the case of Amit).
As a result, we would start the next accounting period with a balance brought forward, and we should therefore consider what entries are needed in the second period.
We will use the same examples as before, continuing into a second year.
Firstly Karen:
During the year to 31 December 2001, Karen made the following payment in respect of insurance:
Date paid | Amount | Period covered |
12 June 2001 | $2,400 | for the 12 months to 30 June 2002 |
(a) Show extracts from the Statement of Profit or Loss and Statement of Financial Position
(b) Write up the t-accounts for Insurance and for Prepayments for the year to 31 December 2001
(c) Close off the accounts
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The fourth lecture works Example 4 and explains what happens when an accrual estimate turns out to be slightly wrong. None of the four lectures covers section 5 (accrued and prepaid income) — read it here; it uses exactly the same reasoning, the other way round.
Now Amit:
During the year to 31 March 2002 he made the following payments in respect of telephone:
Date paid | Amount | Period covered |
12 April 2001 | $950 | for the 3 months to 31 March 2001 |
15 July 2001 | $1,000 | for the 3 months to 30 June 2001 |
24 October 2001 | $1,200 | for the 3 months to 30 September 2001 |
12 January 2002 | $1,350 | for the 3 months to 31 December 2001 |
As at 31 March 2002, Amit estimated that $1,500 was owing for the 3 months to 31 March. He had however not received a bill from the telephone company.
You are required to:
(a) Show extracts from the Statement of Profit or Loss and Statement of Financial Position
(b) Write up the t-accounts for Telephone and for Accruals for the year to 31 March 2002
(c) Close off the accounts
Show answerHide answer
An accrual is often an estimate. If the bill turns out slightly different (say $960 instead of the $950 accrued), nothing is reopened: last year’s statements stand, and the $10 difference simply falls into this year’s expense when the reversal and the actual payment are recorded. In practice the accounts are usually finished some weeks after the year end, by which time the bill has often arrived.
5 Accrued and prepaid income
Income is treated in the same way as expenses: the statement of profit or loss shows the income earned in the period, whether or not the cash has been received.
Accrued income is income earned in the period but not yet received at the year end — for example rent or commission owed to the business. It is added to the income for the year and shown as a current asset (like a receivable). Journal: Dr Accrued income, Cr the income account.
Prepaid income (income received in advance, also called deferred income) is cash received in the period for income that belongs to the next period. It is taken out of this year’s income and shown as a current liability, because the business still owes the service. Journal: Dr the income account, Cr Prepaid income.
Fernando’s business has a year end of 31 December 2001. It sublets part of its premises at a rent of $1,000 a month, and during the year it received $13,000 of rent — the twelve months of 2001 plus $1,000 paid early by the tenant for January 2002. It also earns commission from a supplier: commission earned for 2001 was $9,600, of which $8,800 had been received by 31 December; the $800 for December was received in January 2002.
Rent received | Commission receivable | |
Cash received in the year | 13,000 | 8,800 |
Less: prepaid income (rent for January 2002) | (1,000) | — |
Add: accrued income (commission for December 2001) | — | 800 |
Income in the statement of profit or loss | 12,000 | 9,600 |
In the statement of financial position at 31 December 2001: current asset, accrued income $800; current liability, prepaid income (rent received in advance) $1,000.
Debit | Rent received | Credit | |
Prepaid income | 1,000 | Cash | 13,000 |
Statement of profit or loss | 12,000 | ||
13,000 | 13,000 | ||
Debit | Commission receivable | Credit | |
Statement of profit or loss | 9,600 | Cash | 8,800 |
Accrued income | 800 | ||
9,600 | 9,600 | ||
Next year both balances are reversed on the first day, exactly as for expenses: Dr Prepaid income, Cr Rent received $1,000; Dr Commission receivable, Cr Accrued income $800.
6 Summary of entries
Each step below is a journal entry (debit first, then credit). In an exam you are usually asked for the figures in the statements rather than the t-accounts — the quickest working is:
Expense for the year = cash paid + opening prepayment − closing prepayment − opening accrual + closing accrual
Income for the year = cash received + opening prepaid income − closing prepaid income − opening accrued income + closing accrued income
(a) Prepayments (expenses paid in advance)
Step | Debit | Credit |
1. Reverse any prepayment brought forward | Expense account (e.g. Insurance, Rates) | Prepayments account |
2. Enter any payments during the period | Expense account | Cash account |
3. Enter any prepayment at the end of the period | Prepayments account | Expense account |
4. Close off: transfer the balance on the expense account to the Statement of Profit or Loss | Statement of Profit or Loss t-account | Expense account |
Leave the balance on the prepayments account and show in the Statement of Financial Position (current asset).
(b) Accruals (expenses owing)
Step | Debit | Credit |
1. Reverse any accrual brought forward | Accruals account | Expense account (e.g. Telephone, Electricity) |
2. Enter any payments during the period | Expense account | Cash account |
3. Enter any accrual at the end of the period | Expense account | Accruals account |
4. Close off: transfer the balance on the expense account to the Statement of Profit or Loss | Statement of Profit or Loss t-account | Expense account |
Leave the balance on the accruals account and show in the Statement of Financial Position (current liability).
(c) Income
Step | Debit | Credit |
Income received in advance at the end of the period | Income account | Prepaid income account (current liability) |
Income earned but not received at the end of the period | Accrued income account (current asset) | Income account |
Close off: transfer the balance on the income account | Income account | Statement of Profit or Loss t-account |
Reverse both balances at the start of the next period.
7 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
Accruals and Prepayments
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