CHAPTER 9: ACCRUALS AND PREPAYMENTS

Learning objectives:

After studying this chapter, students will be able to:

 Identify the accounting principles behind accruals and prepayments;

 Calculate figures in the statement of financial position for accruals and

prepayments of expenditure;

 Calculate figures in the statement of financial position for accrued and

deferred income (arrears and advances);

 Identify the correct figures in the statement of profit or loss for income and
expenses;

 Identify the effects of accruals and prepayments of income and expenses on

profit for the period in the SOPL

 Specify how the initial trial balance should be adjusted to reflect year-end
accruals and prepayments.

Topic list:

1. The principle behind accruals and prepayments

2. Accruals

3. Prepayments

4. Accounting for accruals and prepayments

5. The accrual principle and income

6. Accruals, prepayments, advances and arrears and the TB

1. The principle behind accruals and prepayments
Financial statements are prepared under the Accruals Basis of accounting which
requires that income and expense must be recognized in the accounting periods to
which they relate rather than on cash basis. An exception to this general rule is the
cash flow statement whose main purpose is to present the cash flow effects of
transaction during an accounting period.

Accruals (or accrued expenses) are expenses which are charged against the profit
for a particular period, even though they have not yet been paid for.\

Prepayments (or prepaid expenses) are expenses which have been paid in one
reporting period, but are not charged against profit until a later period, because
they relate to that later period.

The accrual basis requires that we match expenses with the revenue generated by
them. Matching principle requires accountants to record revenues and expenses in
the period in which they are incurred regardless of when the relevant payments are
made. In order to create this 1-on-1 correspondence between revenue and
expenses, expenses are recorded if they are incurred in a particular period even if
they are not yet paid, because they were necessary to earn the revenue for that
period. On the other hand, prepayments are recorded to represent payments related
to goods and services that are to be consumed in future periods. It is this matching
principle that differentiates accrual accounting from cash-basis accounting, which
records revenues and expenses when they are received and not when they are
earned or incurred. Therefore, we sometimes therefore need to carry forward actual
expenditure to a subsequent period (a prepayment), or account for expenditure
incurred before it is actually paid for (an accrual).
2. Accruals
Accruals are expenses incurred but not yet paid. To set up an accrual:

DEBIT Expense (SPL) £X

CREDIT Accrual (liability on SFP) £X

WORKED EXAMPLE:

Horace Goodrunning ends his motor spares business’s reporting period on 28

February each year. His telephone was installed on 1 April 20X6 and he receives
his telephone bill quarterly at the end of each quarter. We need to calculate the
telephone expenses to be charged to the statement of profit or loss for the year
ended 28 February 20X7.

Telephone expense for the three months ended: (£)

30.6.20X6: 23.50

30.9.20X6: 27.20

31.12.20X6: 33.40

31.3.20X7: 36.00

All the bills were paid on the final day of each three-month period.

INTERACTIVE QUESTION 1:

Cleverley started in business as a paper plate and cup manufacturer on 1 January

20X2, preparing financial statements to 31 December 20X2. He is not registered
for VAT. Electricity bills received in respect of charges for the previous quarter
were as follows: (£)
 20X2 20X3

31 January - 491.52

30 April 279.47 400.93

31 July 663.80 700.94

31 October 117.28 620.00

Requirement:

What is the electricity expense for the year ended 31 December 20X2?

3. Prepayments
Prepayments are payments for expenses for that are not yet incurred.

To set up a prepayment:

DEBIT Prepayment (asset in SFP) £X

CREDIT Expense (SPL) £X

WORKED EXAMPLE:

A business opens on 1 January 20X4 in a shop where the rent is £20,000 per year,
payable quarterly in advance at the beginning of each three month period.
Payments were made as follows:

1 January 20X4 5,000

31 March 20X4 5,000

30 June 20X4 5,000

 30 September 20X4 5,000

31 December 20X4 5,000

Requirement:

What is the rental expense for the year ended 31 December 20X4

4. Accounting for accruals and prepayments

Recording accruals and prepayments:

Reversing accruals and prepayments:

5. The accrual principle and income
Accrued income arises when receipt of income (such as rent or subscription) is in
arrears at the year end

Deferred income arises when income has been received in advance at the end of
the reporting period, so it needs to be carried forward and treated as income of the
following reporting period.

 Accounting for accrued income

DEBIT Accrued income (asset in SFP) £X

CREDIT Other income (SPL) £X

 Accounting for deferred income:

DEBIT Revenue or other income (SPL) £X

CREDIT Deferred income (liability in SFP) £X

6. Accruals, prepayments, advances and arrears and the TB

1) Calculate amount accrued/prepaid items

2) Prepare adjustment journals

3) Enter journals in adjustment column in TB

4) Cross-cast

5) Enter closing journals

6) Prepare reversal of accrued/prepaid items

Example:
Woodworks, Inc. is a furniture manufacturer and retailer. You are closing the
books of the company for the year ended 30 June 20X0. Suggest appropriate
accounting treatment for the following transactions:

- The company paid salaries of £70,000 for June 20X0 on 4 July 20X0. Total
salaries for the year 20X0 do not already include this figure.
- On 5 July 20X0, the company received utility bills totaling £30,000.
- Annual rent of £100,000 on Outlet A was paid on 1 January 20X0 and it was
recorded as prepaid rent.
- Semi-annual rent of £30,000 on Outlet B was also paid on 1 April 20X0 and
the whole amount was charged to the P/L.
- On 30 June 20X0, £50,000 was paid on account of 5-year premium
membership of relevant business association.
Journal entries:

The basic principle behind accrual accounting is to record revenues and expenses
regardless of payment. Following accrual and prepayment adjustments are required
for 20X0.

Though salaries of £70,000 were paid on 4 July 20X0, they related to services
provided by employees in June 20X0. These salaries are the cost of June 20X0
revenue and must be recorded as part of June financial statements even if the
payment is made after 30 June. The following journal entry must be made:

Salaries expense £70,000

Salaries payable £70,000

On 4 July 20X0, at the time of actual payment is made, the following journal entry
is made:
 Salaries payable £70,000

Cash £70,000

Utility bills related to utilities consumed in June, so they must be reflected in

financial statements for the year ended 30 June 20X0, even if they are paid later.

Utilities expense £30,000

Utilities payable £30,000

When the bills are actually paid, the following journal entry reflects the actual
payment:

Utilities payable £30,000

Cash £30,000

12 months of rent was paid on 1 January 20X0 and it was recorded as prepaid rent.
Half of this rent is related to the year ended 30 June 20X0, so a journal entry
should be made to expense out half of the prepaid rent.

Rent expense (£100,000/2) £50,000

Prepaid rent £50,000

In April 20X0, £30,000 was paid on account of six months of rent on Outlet B and
it was expensed out. However, only three months of the relevant rent payment
belong to financial year 20X0. A journal entry should be made to reduce the
recorded rent expense and create a prepaid rent asset equivalent to three months of
use.

Prepaid rent (£300,000/6×3) £15,000

 Rent expense £15,000

The payment of £50,000 on 30 June 20X0 relates to membership fee due in next 5
year. This payment is a prepayment.

Prepaid membership fee £50,000

Cash £50,000

This prepaid membership fee will be expensed out proportionately in next 5 years.