Accruals and Prepayments Notes PDF

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Accruals and Prepayments Notes...

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10: ACCRUALS AND PREPAYMENTS

Overview

Accruals and prepayments

Accounting treatment

Year end adjustments

Reversing out accruals and prepayments

Accrued income and deferred income

Accounting treatment

162

Presentation in the statement of financial position

10: ACCRUALS AND PREPAYMENTS

1

Introduction

1.1

This chapter is designed to enable you to apply accounting concepts and principles in relation to the calculation of and adjustments for accruals and prepayments.

1.2

IAS 1 requires financial statements to be prepared on an accruals basis. This is so that transactions and events are recognised when they occur (even if the resulting cash receipts and payments occur in a different period) and they are recorded in the accounting records and reported in the financial statements of the period to which they relate. Accrual accounting is also required in reporting financial performance by the IASB's Conceptual Framework.

Accruals 1.3

Accruals are expenses incurred by the business during the accounting period but not yet paid for, ie expenses in arrears.

Example 1.4

Fred prepares accounts to 31 December each year. On 1 January 20X8, he pays a telephone bill of $60 which relates to the period October–December 20X7. Although the payment does not go through the cash book until 20X8, this expense must be included in the accounts for the year ended 31 December 20X7, as it was incurred during this period.

Prepayments 1.5

Prepayments arise when expenses are paid for before they have been used, ie expenses in advance.

Example 1.6

On 20 December 20X7 Fred pays for insurance on his business premises for the 12 months commencing 1 January 20X8. Although the payment was made in 20X7, the expense should not appear in the accounts for 20X7. The accounts for 20X7 will show a prepayment for the full amount of the insurance cost and the expense will be recorded in 20X8.

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2

Accounting treatment

Year-end adjustments 2.1

Adjustments for accruals and prepayments tend to occur at the end of the year and are made by way of a journal entry. The required entries are: Accruals Dr Expense (SPL) Cr Accruals (SOFP) Prepayments Dr Prepayments (SOFP) Cr Expense (SPL)

Presentation in the statement of financial position 2.2

Accruals: Sub-heading under 'current liabilities' Prepayments: Sub-heading under 'current assets'.

Lecture example 1

Preparation question

Fiona set up a business on 1 January 20X7. Her cash payments for the year to 31 December 20X7 included: Date paid

Amount $

Period

Electricity 10.3.X7

96

2 months to 28 February 20X7

12.6.X7

120

quarter to 31 May 20X7

14.9.X7

104

quarter to 31 August 20X7

10.12.X7

145

quarter to 30 November 20X7

1.2.X7

375

3 months to 31 March 20X7

6.4.X7

1,584

Rent 12 months to 31 March 20X8

Note: On 6 March 20X8 Fiona received an electricity bill for $168 for the quarter to 28 February 20X8.

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10: ACCRUALS AND PREPAYMENTS Required (a)

Calculate the expense incurred by Fiona for electricity and rent for the year ended 31 December 20X7.

(b)

Calculate the amount of any accruals/prepayments at the end of the year.

(c)

State the journal entry required for the year-end adjustments.

Solution

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10: ACCRUALS AND PREPAYMENTS

Lecture example 2

Preparation question

Required Using the figures from Lecture example 1: Complete the necessary entries in Fiona's ledger accounts as at 31 December 20X7, then balance off the accounts.

Solution

10.3.X7 12.6.X7 14.9.X7 10.12.X7

1.2.X7 6.4.X7

Cash Cash Cash Cash

Electricity expense (SPL) $ 96 120 104 145

Cash Cash

Rent expense (SPL) $ 375 1,584

$

$

Accruals (SOFP) $

$

Prepayments (SOFP) $

$

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10: ACCRUALS AND PREPAYMENTS

Lecture example 3

Preparation question

In 20X8 Fiona paid the following electricity bills: Date paid

Amount $

Period

12.3.X8

168

quarter to 28 February 20X8

9.6.X8

134

quarter to 31 May 20X8

12.9.X8

118

quarter to 31 August 20X8

12.12.X8

158

quarter to 30 November 20X8

During March 20X9 Fiona received an electricity bill for $189 for the quarter to 28 February 20X9. Required Calculate the electricity expense and accrual for the year ended 31 December 20X8 and complete the ledger accounts.

Solution Electricity expense (SPL) $

$

Accruals (SOFP) $

$

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10: ACCRUALS AND PREPAYMENTS

Lecture example 4

Exam standard question for 2 marks

The following transactions related to Colin's gas expense ledger account for the year ended 31 December 20X8: $ Prepayment brought forward 1,100 Cash paid 10,800 Accrual carried forward 1,300 What amount should be charged to the statement of profit or loss in the year ended 31 December 20X8 for gas? A B C D

$10,800 $13,200 $10,600 $11,000

Solution

Lecture example 5

Exam standard question for 2 marks

At the year end, a company decides that an accrual of $750 is required for telephone expenses and a prepayment of $200 for insurance. There are no brought forward accruals or prepayments on these expense accounts. What impact will the recording of this accrual and prepayments have on profit and net assets? A B C D

A decrease in profit of $550; a decrease in net assets of $550. An increase in profit of $550; an increase in net assets of $550. A decrease in profit of $950; an increase in net assets of $950 An increase in profit of $950; a decrease in net assets of $950.

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4

Accrued income and deferred income

4.1

Accruals and prepayments relate to when expenses are paid in arrears or advance. Income may also be received in arrears or advance.

Accrued income 4.2

This relates to when income has been earned during the accounting period but not invoiced or received.

Illustration 4.3

Jenny owns a property which she rents out for $3,000 per quarter. The property was occupied all year; however Jenny only received $9,000 in rent because she forgot to send out the final invoice of the year. As the property was let for 12 months, Jenny's statement of profit or loss should show income of $12,000 (4  $3,000) as this is what she has earned. She will therefore need to accrue the 'missing' income of $3,000 as a year end journal and also show a receivable for 'rent in arrears'. The adjustment is: Dr Cr

$ 3,000

Rent in arrears (SOFP) Rental income (SPL)

$ 3,000

The rent in arrears is shown in the statement of financial position within current assets.

Deferred income 4.4

This relates to when income is received in advance of it being earned.

Illustration 4.5

Ben has a year end of December and rents out his property for $1,000 per month. His tenant pays on time each month and during December 20X7 paid Ben $2,000 as he would be away when the January 20X8 payment was due. Ben has received income of $13,000 but only $12,000 of this relates to the current year. He must therefore remove $1,000 of income from this year's accounts because it relates to next year. A liability will also be shown for 'rent in advance'. The adjustment is: Dr Cr

$ 1,000

Rental income (SPL) Rent in advance (SOFP)

$ 1,000

The rent in advance is shown in the statement of financial position within current liabilities.

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10: ACCRUALS AND PREPAYMENTS

Approach to questions 4.6

The approach for accrued income and deferred income is exactly the same as for accruals and prepayments. There are four steps to follow: (1) (2) (3) (4)

Reverse opening rent in arrears/advance. Post cash received during the year. Post closing rent in arrears/advance. Balance off the accounts.

Lecture example 6

Exam standard question for 2 marks

A company receives rent from a large number of properties. The total received in the year ended 30 June 20X7 was $962,400. The following were amounts of rent in advance and in arrears at 30 June 20X6 and 30 June 20X7: 30 June 20X6 $

30 June 20X7 $

Rent received in advance

57,400

62,400

Rent in arrears (all subsequently received)

42,400

36,800

What amount of rental income should appear in the company's statement of profit or loss for the year ended 30 June 20X7? A B C D

$973,000 $921,800 $1,003,000 $951,800

Solution

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5

Chapter summary Section Topic

Summary

1

An entity should produce its financial statements using the accruals basis in accordance with IAS 1 and the Conceptual Framework.

Introduction

Accruals are made when expenses are paid in arrears, whereas prepayments arise when expenses are paid for in advance. 2

Accounting treatment

Accruals increase expenses and are shown as a liability on the statement of financial position at the year end. Prepayments reduce expenses and are an asset on the statement of financial position.

3

Reversing out accruals and prepayments

Accruals and prepayments from the previous year are reversed at the beginning of the next accounting period so that the current year expense is correct.

4

Accrued income and deferred income

These follow a similar theory to accruals and prepayments but relate to income. An entity will accrue income where it has earned the income during the period but not yet invoiced for it. This will increase income and be shown as a receivable at the year end. Where an entity has received income in advance of it being earned it should be deferred to the following period. This will reduce income and be shown as a payable at the year end.

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6

Double Entry Summary for Chapter 10

6.1

Accruals adjustment: Dr Cr

6.2

Prepayments adjustment: Dr Cr

6.3

Expense (SPL) Accruals (SOFP)

Prepayments (SOFP) Expense (SPL)

Approach to questions (four steps): (1)

Reverse opening accrual/ prepayment: Accruals: Dr Accruals (SOFP) Cr Expense (SPL) Prepayments: Dr Expense (SPL) Cr Prepayments (SOFP)

(2)

Post cash paid during the year.

(3)

Post closing accrual/prepayment.

(4)

Balance off the ledger accounts.

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