Accruals and Prepayments

Accruals basis of accounting

• The accruals basis of accounting means that to calculate the profit for
the period, we must include all the income and expenditure relating
to the period, whether or not the cash has been received or paid or
an invoice received.
• Profit is therefore:
Income earned X
Expenditure incurred (X)
Profit X
Accrued expenditure
• An accrual arises where expenses of the business, relating to the year, have
not been paid by the year end.
• In this case, it is necessary to record the extra expense relevant to the year
and create a corresponding statement of financial position liability (called an
accrual):
Dr Expense account X
Cr Accrual X
• An accrual will therefore reduce profit in the income statement.
Illustration 1
• A business’ electricity charges amount to Rs.12,000 pa. In the year to
31 December 20X5, Rs.9,000 has been paid. The electricity for the
final quarter is paid in January 20X6.
• What year-end accrual is required and what is the electricity expense
for the year?
• John Simnel’s business has an accounting year end of 31 December 20X1. He
rents factory space at a rental cost of Rs.5,000 per quarter, payable in arrears.
• During the year to 31 December 20X1 his cash payments of rent have been as
follows:
• 31 March (for the quarter to 31 March 20X1) Rs.5,000
• 29 June (for the quarter to 30 June 20X1) Rs.5,000
• 2 October (for the quarter to 30 September 20X1) Rs.5,000
• The final payment due on 31 December 20X1 for the quarter to that date was
not paid until 4 January 20X2.
• Show the ledger accounts required to record the above transactions.
Prepaid expenditure
• A prepayment arises where some of the following year’s expenses
have been paid in the current year.
• In this case, it is necessary to remove that part of the expense which
is not relevant to this year and create a corresponding statement of
financial position asset (called a prepayment):
Dr Prepayment X
Cr Expense account X
• A prepayment will therefore increase profit in the income statement.
Illustration 2
• The annual insurance charge for a business is Rs.24,000 pa. Rs.30,000
was paid on 1 January 20X5 in respect of future insurance charges.
• What is the year-end prepayment and what is the insurance expense
for the year?
• Tubby Wadlow pays the rental expense on his market stall in advance.
He starts business on 1 January 20X5 and on that date pays Rs.1,200 in
respect of the first quarter’s rent. During his first year of trade he also
pays the following amounts:
• 3 March (in respect of the quarter ended 30 June) Rs.1,200
• 14 June (in respect of the quarter ended 30 September) Rs.1,200
• 25 September (in respect of the quarter Rs.1,400 ended 31 December)
• 13 December (in respect of the first quarter of 20X6) Rs.1,400
• Show these transactions in the rental expense account.
• On 1 January 20X5, Willy Mossop owed Rs.2,000 in respect of the previous
year’s electricity. Willy made the following payments during the year ended
31 December 20X5:
• 6 February Rs.2,800
• 8 May Rs.3,000
• 5 August Rs.2,750
• 10 November Rs.3,100
• At 31 December 20X5, Willy calculated that he owed Rs.1,800 in respect of
electricity for the last part of the year.
• What is the electricity charge to the income statement?
Accrued income
• Accrued income arises where income has been earned in the
accounting period but has not yet been received.
• In this case, it is necessary to record the extra income in the income
statement and create a corresponding asset in the statement of
financial position (called accrued income):
Dr Accrued income (SFP) X
Cr Income (IS) X
• Accrued income creates an additional current asset on our Statement
of financial position. It also creates additional income on our Income
statement, and hence this will increase overall profits.
Illustration 3
• A business earns bank interest income of Rs.300 per month. Rs.3,000
bank interest income has been received in the year to 31 December
20X5.
• What is the year-end asset and what is the bank interest income for
the year?
Prepaid income
• Prepaid income arises where income has been received in the
accounting period but which relates to the next accounting period.
• In this case, it is necessary to remove the income not relating to the
year from the income statement and create a corresponding liability
in the statement of financial position (called prepaid income):
Dr Income X
Cr Prepaid Income X
• A business rents out a property at an income of Rs.4,000 per month.
Rs.64,000 has been received in the year ended 31 December 20X5.
• What is the year-end liability and what is the rental income for the
year?