Accruals and Prepayments

1 Introduction

One of the fundamental accounting principles is the accruals principle. This states that income and expenses should be matched on a time basis. In particular they should not simply be matched on a cash basis as the receipts and payment of cash is too arbitrary and would not result in consistent or dependable results.

The problem is examined in two parts;

1. Accruals and prepayments in principle
   

2. Accruals and prepayments as handled in the double entry system.
   

2 Accruals and prepayments in principle

It can sometimes be useful to show accruals and prepayments by way of a time-line diagram. For example:

In September 2013, insurance of $2,400 was paid for the year to 30/9/2014. In September 2014, insurance of $3,000 was paid for the year to 30/9/2015. What expense for insurance should be shown in the statement of profit or loss for the year ended 31/12/2014, and what accrual or prepayment would be shown in the statements of financial position as at 31/12/2013 and 31/12/2014?

So, 9 months’ worth of the $2,400 insurance to 30/9/2014 relates to the year to 31/12/2014 and 3 months of the insurance to 30/9/2015 relates to that year also.

Expense y/e 31/12/2014 = $2,400 x 9/12 + $3,000 x 3/12 = $1,800 + $750 = $2,550

Prepayment as at 31/12/2013 = 9/12 x 2,400 = $1,800

Prepayment as at 31/12/2014 = 9/12 x 3,000 = $2,250

3 Accruals and prepayments in ‘T’ accounts.

Consider a business that starts on 1/10/2012 and which makes its first set of accounts up to 31/12/2012, and the next set of accounts up to 31/12/2013.

On 2/10/2012 it pays rent of $6,000 for the year ended 30/9/2013, and on 25/9/2013 pays rent of $7,200 for the year ended 30/9/2014.

The expenses and prepayments for rent are:

Three months to 31/12/2012: Expense = $6,000 x 3/12 = $1,500

Prepayment as at 31/12/2012 = $4,500

12 months to 31/12/2013: Expense = $6,000 x 9/12 + $7,200 x 3/12 = $6,300

Prepayment as at 31/12/2013 = $5,400

In the rent ‘T’ account, these results can be achieved as follows:

As at 31/12/2012, the correct expense is transferred to the statement of profit or loss and this leaves $4,500 in the account, which is carried down as a balance on the debit side. This is an asset and is a prepayment.

During the following year, more rent is paid, the correct amount transferred to the statement of profit or loss and a prepayment carried down.

You can think of the 31/12/2013 expense of $6,300 as:

$4,500 (last time’s prepayment) + $7,200 (cash paid this time) - $5,400 (the prepaid amount within the $7,200) = $6,300.

4 The journal entries

The T accounts above show what happens; the journal is how it is authorised and recorded. At the year end:

Where the accrual and prepayment are carried down as a balance on the expense account itself - which is how this chapter works and how the exam usually shows it - the balance does the same job as a separate Accruals or Prepayments account: it is a credit balance (a liability) for an accrual and a debit balance (an asset) for a prepayment.

Reversal. Whichever way it is recorded, the adjustment is reversed at the start of the next period. That is exactly what the balance brought down does: the $5,400 prepayment brought down on the debit side above becomes part of next year's rent expense without anyone having to remember it. If a separate Accruals account is used, the journal is simply reversed on the first day of the new year.

5 Accrued income and deferred income

Everything so far in this chapter has been about expenses. The accruals principle applies to income in exactly the same way, and the study guide names both sides. The two income items are the mirror images of the two expense items:

Accrued income arises where the business has earned income but has not yet billed or been paid for it - commission earned in December but paid in January, rent receivable for a quarter that ends after the year end, bank interest earned but not yet credited. It is an asset, and it is usually reported with receivables.

Deferred income arises where the business has been paid before it has done the work - a year's subscription received in advance, rent received for a period that has not yet run, a deposit on a job not yet delivered. It is a liability, because the business still owes the customer the goods or the service, and it is reported with payables.

The postings are the mirror image of the expense side:

Notice that in both cases the entry adjusts the income account so that the statement of profit or loss shows the income EARNED in the period, whatever cash came in.

Illustration. A business sublets part of its premises. The rent was $8,400 a year up to 31 January 2014 and $9,600 a year from 1 February 2014, and it is payable quarterly in advance on 1 February, 1 May, 1 August and 1 November. The business's year end is 31 December and every instalment was paid on time.

Work in months. Up to 31 January 2014 the rent is $8,400/12 = $700 a month; from 1 February 2014 it is $9,600/12 = $800 a month, so each instalment received in 2014 is $2,400.

• Brought forward: the instalment received on 1 November 2013 covered November 2013, December 2013 and January 2014. One month of it - $700 - had not been earned at 31 December 2013, so there is $700 of deferred income brought down.

• Earned in 2014: January at $700 plus February to December, 11 months at $800, = $700 + $8,800 = $9,500.

• Carried forward: the instalment received on 1 November 2014 covers November, December and January 2015, so one month - $800 - is deferred income at 31 December 2014.

The income reported for the year is $9,500, not the $9,600 of cash received, and the $800 brought down on the credit side is deferred income: a liability at 31 December 2014, shown within current liabilities. Note how closely this mirrors the rent account earlier in the chapter - the difference is only which side the balance falls on.

Now change one fact. Suppose the tenant did not pay the 1 November 2014 instalment until 10 January 2015. November and December 2014 have still been earned, so the income for the year is still $9,500; but only $7,200 of cash came in, so the account now has a DEBIT balance of $1,600 - two months at $800 of accrued income, an asset shown within receivables. (Check: debit side 9,500 to the statement of profit or loss; credit side 700 + 7,200 cash + 1,600 balance c/d = 9,500; the $1,600 is brought down on the debit side on 1/1/2015.)

6 The effect on profit, net assets and capital

All four adjustments do the same two things at once, and the exam often asks for the second one:

Capital always moves with profit, because profit is added to capital. So if you are told that an accrual of $500 was omitted, you know at once that profit is overstated by $500, liabilities are understated by $500 and capital is overstated by $500 - and that the statement of financial position still balanced, which is why nobody noticed.

Reporting. In the statement of financial position:

• prepayments and accrued income are current assets, usually shown with or inside receivables;

• accruals and deferred income are current liabilities, usually shown with or inside payables.