Chapter 1

Notes to teachers
1 2 3 4 5

Accruals and Prepayments

Start with Chapter 4 of Frank Woods Introduction to Accounting and briefly explain to students how to record expenses and other revenues in the cash book and post entries to the general ledger. Refer to Chapter 10 of Frank Woods Introduction to Accounting and briefly explain to students the accrual concept. Explain the meaning of accrued expenses, prepaid expenses, accrued revenues and unearned revenues with the aid of real-life examples, and why they are treated as current assets or current liabilities. Students should know the alternative names of the above items. Most students have difficulty understanding why accrued revenues and unearned revenues are treated as current assets and current liabilities, respectively. Teachers should clarify the meaning of current assets and current liabilities by doing Try This Activity A3 and A7 with students. If the entries in the accounts of expenses and other revenues are posted from the cash book, they are said to be made on a cash basis. Students should know that the accrual concept is one of the fundamental principles underlying financial reporting. To correspond with the accrual concept, adjustments are required in the accounts of expenses and other revenues at the end of an accounting period. As a result, financial statements can then be prepared on an accrual basis. Two methods are used to adjust for accruals and prepayments. Students should master both methods. Timing is very important in deciding whether an item and how much of an item is accrued or prepaid. Teachers always need to remind students to note the financial years closing date.

7 8

Q1

According to the accrual concept, a firm should only record revenues generated by goods sold or services rendered during a period, rather than the amounts actually received during that period. Similarly, a firm should only record expenses which have been incurred in generating those revenues during the same period, rather than the amounts actually paid during that period. Under cash accounting, revenues are recognised when received and expenses are recognised when paid. Under accrual accounting, revenues are recognised when earned and expenses are recognised when incurred. Accruals refer to expenses that have been incurred during a period but have not been paid by the end of that period. Accruals can also refer to revenues that have been earned during a period but have not been received by the end of that period.

Q2

Q3

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Q4

Prepayments refer to expenses that have been paid during a period but have not been incurred by the end of that period. Prepayments can also refer to revenues that have been received during a period but have not been earned by the end of that period. Accrued expenses are liabilities of the firm and therefore the accrued expense account should be classified as a real account. Accrued revenues are assets of the firm and therefore the accrued revenue account should be classified as a real account.
Accrued Water Charges 2010 Jan 1 Water charges $ 2010 1,240 Jan 1 Balance b/f $ 1,240

Q5 Q6 Q7

Water Charges
2010 Jan 1 Accrued water charges $ 1,240

Accrued Interest Revenue

2010 Jan 1 Balance b/f $ 2010 1,600 Jan 1 Interest Revenue 2010 Jan 1 Accrued interest revenue $ 1,600 Interest revenue $ 1,600

A1 A2 A3 A4 A5 A6 A7 A8

This is because accrued expenses are liabilities that are expected to be repaid within one year. Total expenses for the period will be understated and the net profit for the period will be overstated. This is because accrued revenues are assets that are expected to be converted into cash within one year. Total revenues for the period will be understated and the net profit for the period will also be understated. This is because prepaid expenses represent goods or services that are expected to be consumed within one year. Total expenses for the period will be overstated and the net profit for the period will be understated. This is because unearned revenues represent goods or services that a business has to provide to its customers within one year. Total revenues for the period will be overstated and the net profit for the period will also be overstated.

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A9

K Hui Income Statement for the year ended 31 March 2010 (extract)
$ Other revenues: Rent revenue Commission revenue Expenses: Rent expense Telephone expense 80,000 2,680 100,000 1,140 Insurance 2009 Feb 26 Aug 24 2010 Jan 1 Bank Bank $ 2009 1,800 Dec 31 1,800 " 31 3,600 600 Prepaid Insurance 2009 Dec 31 2010 Jan 1 Insurance Balance b/f $ 2009 600 Dec 31 2010 600 Jan 1 Rent Revenue 2009 Dec 31 " 31 Profit and loss Unearned rent revenue $ 2009 30,000 Sept 24 10,000 Oct 25 Nov 26 Dec 28 40,000 2010 Jan 1 Unearned Rent Revenue 2009 Dec 31 2010 Jan 1 Balance c/f Rent revenue $ 2009 10,000 Dec 31 2010 10,000 Jan 1 Rent revenue Balance b/f $ 10,000 10,000 Bank Bank Bank Bank $ 10,000 10,000 10,000 10,000 40,000 10,000 Balance c/f Insurance $ 600 600 Profit and loss Prepaid insurance $ 3,000 600 3,600

A10

Prepaid insurance

Unearned rent revenue

A11

In the income statement: Net profit for the year would be total revenues received minus total expenses paid during the year. Sales would be the amount actually received from sales during the year. Discounts allowed would not be separately shown. Purchases would be the amount actually paid for purchases during the year. Discounts received would not be separately shown. The matching concept (which will be explained in Chapter 17 of Frank Woods Financial Accounting 2) would no longer apply. Therefore, no adjustments for opening/closing inventory would be required. Rent received in advance would be recognised as revenue for the year. Interest revenue would not be recognised as revenue for the year because it had not been received by the year end. No adjustments for accrued wages and prepaid telephone charges would be required. 3

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In the balance sheet: The items inventory, accounts receivable, accrued revenues and prepaid expenses would not appear in current assets. The items accounts payable, accrued expenses and unearned revenues would not appear in current liabilities.

A13

Accrual accounting can more accurately measure the financial performance (i.e., profitability and liquidity) of an entity. Under cash accounting, revenues represent the amounts received during an accounting period, whether they have been earned or not. The amounts earned but not yet received would not be recorded as revenues while the amounts received but not yet earned would not be excluded and not treated as revenues. Under accrual accounting, revenues represent the amounts earned during an accounting period, whether they have been received or not. The amounts earned but not yet received or received but not yet earned would be shown as current assets and liabilities, respectively, in the balance sheet. Likewise, under cash accounting, expenses represent the amounts paid during an accounting period, whether they have been incurred or not. The amounts incurred but not yet paid would not be recorded as expenses while the amounts paid but not yet incurred would not be excluded and not treated as expenses for the period. Under accrual accounting, expenses represent the amounts incurred during an accounting period, whether they have been paid or not. The amounts paid but not yet incurred or incurred but not yet paid would be shown as current assets and liabilities, respectively, in the balance sheet.

ASSESSMENT

Short Questions
1
(i)
2008 Dec 31 " 31 Bank Accrued c/f

Rent
$ 2008 16,000 Dec 31 4,000 20,000 Profit and loss $ 20,000 20,000

(ii)
2008 Dec 31 Bank

Insurance
$ 2008 900 Dec 31 " 31 900 Profit and loss Prepaid c/f $ 635 265 900

(iii)
2008 Jan 1 Jul 1 Bank Bank

Rates
$ 2008 750 Dec 31 1,125 " 31 1,875 Profit and loss 3 Prepaid c/f ($1,125 ) 9 $ 1,500 375 1,875

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(iv)
2008 Dec 31 " 31 Profit and loss ($4,000 12) In advance c/f

Rent Revenue
$ 2008 48,000 Apr 15 16,000 Dec 15 64,000 Bank Bank $ 20,000 44,000 64,000

2X

(i)
2009 Mar 31 Bank

General Expenses
$ 2009 6,150 Mar 31 " 31 6,150 Profit and loss Prepaid c/f $ 5,590 560 6,150

(ii)
2009 Mar 31 Profit and loss

Commission Revenue
$ 2009 3,231 Mar 31 " 31 3,231 Bank Accrued c/f $ 3,056 175 3,231

(iii)
2009 Mar 31 " 31 Bank Accrued c/f

Carriage Outwards
$ 2009 666 Mar 31 122 788 Profit and loss $ 788 788

(iv)
2008 Apr 1 2009 Jan 1 Bank Bank

Insurance
$ 2009 1,080 Mar 31 " 31 1,080 2,160 Profit and loss Prepaid c/f ($1,080 6 ) 9 $ 1,440 720 2,160

(i)
2008 Dec 31 Bank " 31 Accrued rent

Rent
$ 16,000 4,000 20,000 2008 $ Dec 31 Profit and loss 20,000 20,000

Accrued Rent
2008 $ Dec 31 Balance c/f 4,000 2008 Dec 31 Rent $ 4,000

The Journal
Date 2008 Dec Details 31 Rent Accrued rent Dr $ 4,000 Cr $ 4,000

(ii)
2008 Dec 31 Bank

Insurance
$ 900 2008 Dec 31 Profit and loss " 31 Prepaid insurance $ 635 265 900 2008 Dec 31 Insurance

Prepaid Insurance
$ 265 2008 Dec 31 Balance c/f $ 265

900

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The Journal
Date 2008 Dec Details 31 Prepaid insurance Insurance Dr $ 265 Cr $ 265

(iii)
2008 Jan 1 Bank Jul 1 Bank

Rates
$ 750 1,125 2008 $ Dec 31 Profit and loss 1,500 " 31 Prepaid rates 375 1,875 2008 Dec 31 Rates

Prepaid Rates
$ 375 2008 Dec 31 Balance c/f $ 375

1,875

The Journal
Date 2008 Dec Details 31 Prepaid rates Rates Dr $ 375 Cr $ 375

(iv)

Rent Revenue
2008 Apr 15 Bank Dec 15 Bank $ 20,000 44,000

Unearned Rent Revenue

2008 Dec 31 Balance c/f $ 16,000 2008 $ Dec 31 Rent revenue 16,000

2008 $ Dec 31 Profit and loss 48,000 " 31 Unearned rent revenue 16,000 64,000

64,000

The Journal
Date 2008 Dec Details 31 Rent revenue Unearned rent revenue Dr $ 16,000 Cr $ 16,000

4X

(i)
2009 Mar 31 Bank

General Expenses
$ 6,150 2009 $ Mar 31 Profit and loss 5,590 " 31 Prepaid general expenses 560 6,150

Prepaid General Expenses

2009 Mar 31 General expenses $ 560 2009 Mar 31 Balance c/f $ 560

6,150

The Journal
Date 2009 Mar Details 31 Prepaid general expenses General expenses Dr $ 560 Cr $ 560

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(ii)

Commission Revenue
$ 3,231 2009 $ Mar 31 Bank 3,056 " 31 Accrued commission revenue 175 3,231

Accrued Commission Revenue

2009 $ Mar 31 Commission revenue 175 2009 Mar 31 Balance c/f $ 175

2009 Mar 31 Profit and loss

3,231

The Journal
Date 2009 Mar Details 31 Accrued commission revenue Commission revenue Dr $ 175 Cr $ 175

(iii)

Carriage Outwards
2009 Mar 31 Profit and loss $ 788 788

Accrued Carriage Outwards

2009 Mar 31 Balance c/f $ 122 2009 Mar 31 Carriage outwards $ 122

2009 $ Mar 31 Bank 666 " 31 Accrued carriage outwards 122 788

The Journal
Date 2009 Mar Details 31 Carriage outwards Accrued carriage outwards Dr $ 122 Cr $ 122

(iv)
2008 Apr 1 Bank 2009 Jan 1 Bank

Insurance
$ 1,080 1,080 2,160 2009 $ Mar 31 Profit and loss 1,440 " 31 Prepaid insurance 720 2,160 2009 Mar 31 Insurance

Prepaid Insurance
$ 720 2009 Mar 31 Balance c/f $ 720

The Journal
Date 2009 Mar Details 31 Prepaid insurance Insurance Dr $ 720 Cr $ 720

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5
Sales Less Cost of goods sold: Opening inventory Add Purchases

C Chan Income Statement for the year ended 31 December 2008

$ $ 92,950

Less Closing inventory Gross profit Less Expenses: Rent ($6,400 $1,600) Wages and salaries ($21,400 + $2,900) Insurance ($590 $190) Telephone ($300 + $110) General expenses Net profit

10,250 55,850 66,100 (19,550)

(46,550) 46,400

4,800 24,300 400 410 1,800

(31,710) 14,690

6X
Sales Less Returns inwards Less Cost of goods sold: Opening inventory Add Purchases

K Chu Income Statement for the year ended 31 March 2009

$ 108,380 (2,000) 8,620 61,120 69,740 (12,120) $ 106,380

Less Closing inventory Gross profit Less Expenses: Wages and salaries ($24,800 + $1,020) Motor expenses Rent and rates ($12,000 $800) Discounts allowed Lighting expenses ($580 + $170) Computer operating expenses ($1,210 $280) General expenses Net profit

(57,620) 48,760

25,820 2,120 11,200 290 750 930 3,600

(44,710) 4,050

Happy Wong Income Statement for the year ended 31 December 2008
$ Hairdressing revenue Less Expenses: Advertising 2) Car expenses ($4,800 3 Rates ($1,400 $300) Telephone Sundry expenses Cleaning Net profit $ 100,400

2,300 3,200 1,100 1,100 1,200 150

(9,050) 91,350

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Happy Wong Balance Sheet as at 31 December 2008

$ Non-current assets Shop premises Equipment Car Current assets Prepaid expenses Bank Cash Less Current liabilities Accrued expenses Net current assets Financed by: Capital as at 1 January 2008 Add Net profit for the year Less Drawings [$4,500 + ($4,800 1 )] 3 $ 60,000 7,200 26,400 93,600 300 5,400 400 6,100 (150) 5,950 99,550 14,300 91,350 105,650 (6,100) 99,550

8X

L Tang Income Statement for the year ended 31 December 2009

$ Sales Less Returns inwards Less Cost of goods sold: Opening inventory Add Purchases Less Returns outwards Add Carriage inwards Less Closing inventory Gross profit Add Other revenues: Discounts received Rent revenue Less Expenses: Discounts allowed Carriage outwards Motor expenses ($4,917 + $330) Repairs to premises Salaries and wages Sundry expenses ($807 + $162) Rates and insurance ($2,896 $332) Loan interest Net profit $ 120,320 (1,384) 30,816 84,290 (810) 83,480 309 114,605 (36,420) $ 118,936

(78,185) 40,751

506 2,500

3,006 43,757

410 218 5,247 1,383 16,184 969 2,564 4,000

(30,975) 12,782

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(a)

T Lee Income Statement for the year ended 30 June 2009

$ $ 108,600

Fees charged Less Expenses: Wages and salaries ($31,960 + $2,320) Postage and stationery ($2,140 + $220) Telephone Computer operating expenses Travel expenses ($1,620 90%) Insurance ($890 $170) Rent ($23,000 $600) Sundry expenses Net profit

34,280 2,360 1,250 2,190 1,458 720 22,400 520

(65,178) 43,422

T Lee Balance Sheet as at 30 June 2009

$ Non-current assets Office furniture Equipment Current assets Accounts receivable Prepaid expenses ($600 + $170) Bank Cash Less Current liabilities Accrued expenses ($220 + $2,320) Net current assets Financed by: Capital as at 1 July 2008 Add Net profit for the year Less Drawings [$9,200 + ($1,620 10%)] $ 10,800 25,400 36,200 11,100 770 8,090 120 20,080 (2,540) 17,540 53,740 19,680 43,422 63,102 (9,362) 53,740

(b) No, both types of firms treat revenues and expenses in the same manner if they adopt accrual-basis accounting. For trading firms, revenues are recognised when goods are sold. For service firms, revenues are recognised when services are provided. As for expenses, they are recognised by both types of firms when they are incurred.

10

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Application Problems
10X
Date 2009 Mar " " " 31 31 31 31 Details Bank Rent revenue Rent revenue Profit and loss ($340,000 + $24,000 $65,000 $38,000 + $42,000) Insurance Bank Profit and loss 3 3 Insurance [$18,000 + ($12,000 12 ) ($18,000 12 )]

The Journal
Dr $ 340,000 303,000 303,000 18,000 18,000 16,500 16,500 Cr $ 340,000

11X
2007 Mar 31 " 31 Balance b/f Accrued c/f

Salaries
$ 2007 9,880 Mar 31 2,300 12,180 Profit and loss $ 12,180 12,180

Electricity
2007 Mar 31 " 31 Balance b/f Accrued c/f $ 2007 5,875 Mar 31 625 6,500 Profit and loss $ 6,500 6,500

Rental Income
2007 Mar 31 " 31 Profit and loss Prepaid c/f $ 2007 150,000 Mar 31 12,500 162,500 Balance b/f $ 162,500 162,500

12

(a)  One of the main differences between cash accounting and accrual accounting lies in the treatment of accruals and prepayments of revenues and expenses.  Under cash accounting, revenues are recorded when cash is received and expenses are recorded when cash is paid. This means that revenues are recognised when received and expenses are recognised when paid.  Under accrual accounting, a firm should only record revenues generated by goods sold or services rendered during a period and the expenses which have been incurred in generating those revenues during the same period, rather than the amounts actually received or paid during that period. This means that revenues are recognised when earned and expenses are recognised when incurred. (b)  Cash accounting often leads to misleading results as a firm may have earned certain revenues during a period but those revenues have not been recognised because they have not been received by the end of that period. Likewise, it may have incurred certain expenses during a period but those expenses have not been recognised as they have not been paid by the end of that period. Owing to its inadequacy, cash accounting is not commonly used by businesses. 11

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13

(a)

Jimmy Chan Income Statement for the year ended 31 March 2010
$ $ 182,480 (97,200) 85,280

Sales Less Purchases Gross profit Less Expenses: Administrative expenses Selling and distribution expenses Net profit

42,570 21,230

(63,800) 21,480

(b)

Jimmy Chan Income Statement for the year ended 31 March 2010
$ $ 194,610

Sales ($182,480 + $12,130) Less Cost of goods sold: Purchases ($97,200 + $7,790) Less Closing inventory Gross profit 4 Add Interest revenue ($50,000 6% ) 12 Less Expenses: Administrative expenses ($42,570 + $6,000) 9 Selling and distribution expenses [$21,230 ($2,400 )] 12 Net profit

104,990 (14,700)

(90,290) 104,320 1,000 105,320

48,570 19,430

(68,000) 37,320

(c)

In (a), sales were recognised when cash was received. In (b), sales were recognised when sales

were made, thus including trade receivables which arose during the year. In (a), purchases were recognised when cash was paid. In (b), purchases were recognised when goods were obtained, thus including trade payables which arose during the year. In (a), the gross profit was calculated by deducting purchases paid during the year from sales receipts for the year. In (b), the gross profit was calculated by deducting the cost of goods sold for the year from sales for the year. The cost of goods sold equalled the purchases made during the year less the value of unsold goods at the year end.  In (a), interest revenue was not recognised because it had not been received by the year end. In (b), interest revenue was recognised because it had been earned during the year. In (a), expenses were recognised when paid. In (b), expenses were recognised when incurred, thus including the amounts accrued and deducting the amounts prepaid. As a result, the net profits calculated in (a) and (b) were different.
Advertising and Promotions
Bank Bank $ 2008 7,500 Apr 1 12,600 2009 Mar 31 " 31 20,100 Accrued b/f Profit and loss Prepaid c/f $ 2,220 14,400 3,480 20,100

14X (a) (i)

2008 Jul 28 Oct 15

12

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(ii)
2008 Apr 1 Sept 14 2009 Feb 12 Mar 31 Stationery b/f Bank Stationery Bank Printing Accrued printing c/f

Printing and Stationery

$ 2009 20,400 Mar 31 5,100 " 31 2,520 3,690 31,710 Profit and loss Stationery c/f $ 13,110 18,600

31,710

(iii)
2009 Mar 31 " 31 Profit and loss (12 months) In advance c/f (3 months: $8,880 1 ) 2

Rental Income
$ 2008 15,780 Apr 1 4,440 Jul 1 Oct 1 20,220 In advance b/f (3 months) Bank (6 months) Bank (6 months) $ 3,780 7,560 8,880 20,220

(iv)
2008 Apr 1 Jul 1 Oct 1 Prepaid b/f (3 months) Bank (6 months) Bank (6 months)

Rates
$ 2009 4,680 Mar 31 10,080 " 31 10,080 24,840 Profit and loss (12 months) Prepaid c/f (3 months: $10,080 1 ) 2 $ 19,800 5,040 24,840

(b)
Current assets Stationery inventory Prepayments ($3,480 + $5,040)

Financial Services Balance Sheet as at 31 March 2009 (extract)

$ Current liabilities 18,600 Accrued expenses 8,520 Unearned revenues $ 3,690 4,440

Past Exam Questions

15
2006 Mar 31 Balance b/f

Insurance Account
$ 2006 8,100 Mar 31 " 31 8,100 Profit and loss 3 Prepayment c/f ($2,780 )
12

$ 7,405 695 8,100

Electricity Account
2006 Mar 31 " 31 Balance b/f Accrual c/f $ 2006 6,480 Mar 31 1,560 8,040 Profit and loss $ 8,040 8,040

Commission Income Account

2006 Mar 31 " 31 Profit and loss Prepaid income c/f $ 2006 188,000 Mar 31 12,000 200,000 Balance b/f $ 200,000 200,000

Rental Income Account

2006 Mar 31 Profit and loss $ 2006 140,000 Mar 31 " 31 140,000 Balance b/f Accrued income c/f $ 120,000 20,000 140,000

13

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