Accruals and prepayments

Sunday, March 28, 2021 3:50 AM

Accruals Basis of accounting

• Cash basis vs Accruals basis

• Accruals basis means that :

(i) The transactions are recorded when revenues are earned and when expenses are incurred.

(ii) This pays no regard to the timing of cash payment or receipt.

• Accrual accounting concerns the timing of the recognition of transactions.

• As such, Under accrual accounting, the statement of profit or loss must include all income and expenses related to the period ,
regardless of the timing of cash receipts or payments.

• The concept is that income and expenses should be matched together and dealt with in the statement of profit or loss for the
period to which they relate, regardless of the period in which the cash was actually received or paid.

• Accruals accounting is applied to:

○ Receivables and Payables

When goods are sold or bought on credit, the sale or the purchase is recorded immediately, and receivables and payables
are created. As a result, the income (Sales) and expense (Purchases) is recognised even though there has been no actual
payment.

○ Business Expenses and Income

The same logic used for credit sales and purchase transactions is applied to other expenses or income of the business, such
as rental, electricity and insurance fees.

Matching Concept
• The matching concept is the extension of accruals concept. This exists only in accrual accounting.

• The matching concept is an accounting practice whereby firms recognize revenues and their related expenses in the same
accounting period. Firms report "revenues," that is, along with the "expenses" that brought them. The purpose of the matching
concept is to avoid misstating earnings for a period.

• This principle requires that you match revenues with the expenses incurred to earn those revenues, and that you report them
both at the same time.

• This means that if you owned a store and spent money to purchase items for your inventory, you wouldn't record that expense
until you sold the items for revenue. Further, you would record only the portion of the expense attributable to each individu al
item as it got sold.

• Similarly, if you ran a crafts business, you wouldn't record the expenses involved in producing those crafts until you actual ly sold
the items you had produced.

Accruals concept
• Under accruals accounting, revenue and costs are both:

(i) accrued (recognised as earned or incurred) and

(ii) recorded in the financial statements of the period they relate.

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 • Payment received from income and made for expenses may be made in arrears (received/paid later) or in advance
(received/paid earlier).

• A business may incur expenses with payments/ invoices made in arrears or in advance:

○ Accruals are expenses invoiced/paid in arrears. For example, electricity incurred from January to March is invoiced only at
the end of March. Accruals are reported as a liability in the statement of financial position.

○ Prepayments are expenses invoiced/paid in advance. For example, yearly business insurance is invoiced once at the start
of the year. Prepayments are reported as an asset in the statement of financial position.

• A business may generate income with invoices issued/payments received in arrears or in advance:

○ Accrued Income is income generated for invoices issued/payments received in arrears. For example, a business may rent
out additional space in an office and collect rental income at the end of the month. Accrued income is reported as
a asset in the statement of financial position.

○ Deferred Income is income generated with invoices issued/ payments received in advance. For example, a business may
collect rental income only at the end of the month. Deferred income is reported as an liability in the statement of financial
position.

• The mismatches between the timing of transactions and their cash flow give rise to the following in the statement of financia l
position:

• This chapter discusses accruals, prepayments, accrued income and deferred income. The double entries below will only be made
at the financial year-end.

Accruals and prepayments - Spreadsheet

Category Explanation Asset Liability Double Entry

Accruals Expenses incurred before invoice received/payment made ✓ DR Expenses

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Accruals Expenses incurred before invoice received/payment made ✓ DR Expenses
CR Accruals
Prepayments Payment invoiced before expenses incurred ✓ DR Prepayments
CR Expenses
Accrued Income Income earned before being invoiced ✓ DR Accrued Income
CR Income
Deferred Income Invoiced before income earned ✓ DR Income
CR Deferred Income

Accrued and Prepaid Expenditure

Accrued expenditure Prepaid expenditure
Or Simply ACCRUALS Or Simply PREPAYMENT

• Accruals arises where expenses of the business, relating to the • Prepayment arises where expenses of the business, relating to
year, have not been paid or invoiced for by the year end. the following year, have been paid by the current year.

i.e. business pays in the current financial period for an expense

that relates to the next financial period.

• Usually, a business recognises an expense when it receives a • Usually, a business recognises an expense when it receives an
purchase invoice (credit purchase) or makes a payment (cash invoice and makes payment.
purchase); the double entry would be
DR Expenses
CR Payables/Bank.

• However, certain ongoing expenses may only be invoiced after • However, certain expenses may be invoiced and paid before they
the services have been incurred. This is known as a are incurred. This is known as a payment in advance.
payment in arrears.
• The amount paid for expenses not yet incurred is recognised as a
• The expense that has yet to be invoiced at year-end is prepayment.
recognised as an accrual.

• At year-end, the business will adjust for accruals creation for • During the year, the business makes payments/ receives invoices
expenses incurred before receiving the invoice/making for expenses not yet incurred and records expense payments. At
payment. year-end, the business identifies which payments were made for
expenses not yet incurred. Since expenses are not incurred in the
year, an adjustment for prepayment creation is made
(credits/reduces expenses).

• So, In a financial year, a supplier sends invoices to the business,

and the business makes payments for the expenses.

• During the year, two entries occur for payments of expenses not
yet incurred:
• recording the expense
• creating the prepayment

• However, at year-end, it is identified that the amount paid does

not relate to expenses incurred during the year. Therefore, a
prepayment is recognised to reduce the expense charge for the
year.

i.e. Since expenses have been recognised earlier, although they

have not yet been incurred (only incurred in the next accounting
period), a prepayment is created to reduce the expense charge
during the year.

• In this case, once the accrual amount is established, it is • In this case, once the prepaid amount is established, it is
necessary to record the extra expense relevant to the year necessary to remove the part of the expense which is not
and create a corresponding statement of financial position relevant to this year and create a corresponding statement of

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 and create a corresponding statement of financial position relevant to this year and create a corresponding statement of
liability ( called an accrual ). financial position asset ( called a prepayment ).

Dr. Expense account XX Dr. Prepayment ( Asset ) XX

Cr. Accruals ( Liability ) XX Cr. Expense account XX

• Thus, accrued expenditure will reduce profit in the statement • Thus, prepaid expenditure will increase profit on the statement
of profit or loss and will also create a current liability on the of profit or loss and will also create a current asset on the
statement of financial position, hence reduce net assets. statement of financial position, hence increase net assets.

Following year adjustment Following year adjustment

• In the subsequent accounting period, where the business • In the next accounting period, the business incurs expenses
receives the invoice and makes the payment, as the period progresses. Therefore, the business records
the reversal of the prepayment made in the previous
○ it will reverse the accruals and period. Thus, the Prepayment account is reversed, and the
○ account for the expense payment. expense is recorded.

• The accruals creation and the reversal of accruals are i.e. When the business continues using the expenses in
posted to the relevant ledgers using journals. the next accounting period, it will adjust
for prepayment reversal.
• The opening accruals balance in SOFP is reversed at the
beginning of the period. • The opening prepaid balance in SOFP is reversed at the
beginning of the period.
Dr. Accruals XX
Cr. Expense account XX Dr. Expense account XX
Cr. Prepaid account XX
• The journal entry for the expense payment is:

Dr. Expense XX
Cr. Bank/Cash XX

Pro-forma expense T-account

Expense account
Opening prepaid balance XX Opening accrued expense XX

Bank ( Total paid during the year ) XX Profit or loss ( Total expense for the year ) XX

Closing accrued expense XX Closing prepaid expense XX

XX XX

Accrued and Prepaid Income

Accrued income Prepaid income / Deferred income

• Accrued income arises where income of the business, relating • Prepaid income arises where income of the business, relating to
to the year, have not been received by the year end. the following year, have been received by the current year.

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 Accrued income is recognised when a Deferred income is recognised when a business receives/invoices
business receives/invoices its income in arrears after earning its income before earning it. At year-end, the business received a
it. At year-end, the business has earned income that has not payment related to the following year.
been received.

• In this case, it is necessary to record the extra income relevant • In this case, it is necessary to remove the part of the income
to the year and create a corresponding statement of financial which is not relevant to this year and create a corresponding
position asset ( called an accrued income ). statement of financial position liability ( called a prepaid
income ).
Dr. Accrued income ( Asset ) XX
Cr. Income XX Dr. Income XX
Cr. Prepaid income ( Liability ) XX

• Thus, accrued income will increase profit in the statement of • Thus, prepaid income will reduce profit on the statement of
profit or loss and will also create a current asset on the profit or loss and will also create a current liability on the
statement of financial position. statement of financial position.

Following year adjustment Following year adjustment

• The opening accruals balance in SOFP is reversed at the • The opening prepaid balance in SOFP is reversed at the beginning
beginning of the period. of the period.

Dr. Income XX Dr. Prepaid income XX

Cr. Accrued income XX Cr. Income XX

Pro-forma expense T-account

Income account
Opening accrued income XX Opening prepaid income XX

Profit or loss ( Total income for the year ) XX Bank ( Total receipt during the year ) XX

Closing prepaid income XX Closing accrued income XX

XX XX

ACCRUALS AND PREPAYMENTS

217 Leisure Co owns two properties which it rents to tenants. In the year ended 31 December 20X6, it received $280,000 in respect of property 1 and
$160,000 in respect of property 2 ?

Balances on the prepaid and accrued income accounts were as follows:

31 December 20X6 31 December 20X5

Property 1 13,400 Dr 12,300 Cr
Property 2 6,700 Cr 5,400 Dr

What amount should be credited to the statement of profit or loss for the year ended 31 December 20X6 in respect of rental income?

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