Chapter 10

ACCRUALS AND PREPAYMENTS

 IN THIS CHAPTER
 INTRODUCTION

 ACCRUED EXPENSE

 PREPAID EXPENSE

 ACCRUED INCOME

 PRE-RECEIVED INCOME

 ERRORS IN RECORDING

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INTRODUCTION

The Accruals Concept says that income and expenses should be included in the statement of profit or loss account of the period
in which they are earned or incurred, not when cash is paid or received.

Recording Expenditure and Income

Throughout the year, when an invoice for an expense incurred is paid, this is accounted for by:

Dr Expense
Cr Cash

Similarly, when income is received, this is accounted for by:

Dr Cash
Cr Income

At this stage, consideration is not given to the period to which the invoice or income relates.

Therefore if the following year’s rent is paid in advance, for example, it is still recorded in the ledger accounts this year even
though it does not relate to the current accounting period.

ACCRUED EXPENSE
An accrual arises where expenses of the business, relating to the year, have been incurred but not yet 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. If no invoice has been received, the amount must be estimated: (called an accrual):

Dr Expense account X
Cr Accrued Expense X

The credit entry creates a current liability in the statement of financial position – an accrual expense.

The debit entry ensures that the statement of profit or loss includes the expense relating to the whole year, thus reducing profit
in it.

PREPAID EXPENSE
Expense which has not been incurred but has been paid in advance.

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 Prepaid expense X
Cr Expense account X

The debit entry creates a current asset in the statement of financial position – a prepayment.

The credit entry removes the expense relating to the following year from the current year’s statement of profit or loss, thus
increasing the profit for the year.
EXAMPLE 1

Tonya has paid $16,560 for rent for the six month period to 31 October 20X7.

What accrual or prepayment is required when preparing accounts for the year ended 31 August 20X7?

Answer: $5,520 - Prepayment

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 statement of profit or loss and create a corresponding asset in the statement of
financial position (called accrued income):

Dr Accrued income (SOFP) X

Cr Income (P&L) X

Accrued income is a current asset in the statement of financial position.

PRE-RECEIVED INCOME
Pre-received income (also known as Deferred Income) arises where income has been received in the accounting period but which
relates to the next accounting period (not earned yet). In this case, it is necessary to remove the income not relating to the year
from the statement of profit or loss and create a corresponding liability in the statement of financial position (called pre-received
income):

Dr Income (P&L) X
Cr Pre-received Income (SOFP) X

Pre-received income is a liability in the statement of financial position.

ACCRUED AND PREPAID EXPENSE ACCOUNT – A SUMMARY

Following is the summarised version of maximum adjustments in an expense account including opening and closing accrual and
prepayment.
EXPENSE A/C

Opening prepayment XX Opening accrual XX

Cash (paid) XX P&L (Charge to P&L) XX

Closing accrual XX Closing prepayment XX

_____ _____
XX XX
ACCRUED AND PRE-RECEIVED INCOME ACCOUNT – A SUMMARY

Following is the summarised version of maximum adjustments in an income account including opening and closing accrued and
pre-received income.

INCOME A/C

Opening accrual XX Opening pre-received income XX

P&L (Charge to P&L) XX Cash (received) XX
Closing pre-received income XX Closing accrual XX

_____ _____
XX XX

IMPORTANT POINTS

ITEM NATURE

Accrued expense Current liability

Pre-paid expense Current asset

Accrued income Current asset

Pre-received income Current liability

 If we have incurred an expense in this period which will not be paid for until the next period, we use an accrual to match
the particular expense against the revenue of this period.

EXAMPLE 2
The annual insurance premium for Donald Ltd for the period 1 July 20X6 to June 20X7 is $13,200, which is 10% more than the
previous year. Insurance premiums are paid on 1 July.

What is the statement of profit or loss charge for insurance for the year ended 31 December 20X6?

Answer: $12,600

EXAMPLE 3
The statement of profit or loss for the year ended 31 August 20X7 shows $21,800 for motor expenses. Payments for motor
expenses during the year totalled $19,000 and there was an accrued expense at 1 September 20X6 of $4,600.

What is the accrual/prepayment for motor expenses as at 31 August 20X7?

Answer: Accrued expense - $7,400

EXAMPLE 4

Following is the extract from electricity account of Alpha Co. for the year ended 30 June 20X7:

Electricity Account
Balance b/d (standing charges) $74 Balance b/d (meter usage) 375
Bank $394
Bank $427
Bank $507
Bank $670

The last bill received and paid was for $670 consisting standing charges of $180 for the three months to 31st August 20X7 and
meter charges for the three months to 31st May 20X7.

What is the electricity to the statement of profit or loss of Alpha Co. for the year ended 30 June 20X7?

Answer: $1,740

EXAMPLE 5

Gamma Ltd had rented its building to Beta Ltd. At 31st December 20X8, Beta Ltd owed $5,900 for rent, but at 31st December
20X9, had paid $1,800 in advance. During the year Gamma Ltd had received $26,800 in rental from Beta Ltd.

What is the rental income to be shown in the statement of profit or loss of Gamma Ltd for the year ended 31st December
20X9?

Answer: $19,100

ERRORS IN RECORDING

Errors that occur, while recording of accruals & prepayments, their impact on financial statements and corrections to be made
are as follows:

Case 1
Accrual not treated as accrual (omission).
Expense understated Profit Overstated
Current Liability Understated
The correct double entry has to be passed for the correction of this error.

Case 2
Prepaid expense not treated as prepayment (omission)
Expense overstated Profit understated
Current Assets Understated
The correct double entry has to be passed for the correction of this error.

Case 3
Accrued expense recognised as prepaid expense
Expense understated (Double amount) Profit Overstated (Double amount)
Current Liability Understated (Single amount)

The correct double entry with double amount has to be passed for the correction of this error. The total difference in the amounts
of assets and liabilities will be double the amount of error.
Case 4
Prepaid expense recognised as accrued expense
Expense overstated (Double amount) Profit understated (Double amount)
Current Assets Understated (Single amount)

The correct double entry with double amount has to be passed for the correction of this error the total difference in the amounts
of assets and liabilities will be double the amount of error.

EXAMPLE 6

Timmy is preparing his financial statements for the year ended 30 November 20X7. Timmy has included within his expenses
office rental of $36,000 paid on 1 February 20X7 for the following 18 months.

What is the effect of this error on Roger’s net profit?

Answer: Profit will be understated by $16,000

EXAMPLE 7

Mary has prepared draft financial statements for the year ended 30 June 20X7. The following items still require adjustment:

 The accounts do not include a cost for telephone expense for June 20X7 which is expected to be $1,570.

 The accounts include an advance payment of $2,400 for rent made on 1 February 20X7; the payment is for the next 20
months.

What is the net impact on profit after the correction of above errors, if any?

Answer: Profit will increase by $230

EXAMPLE 8

Ross’s financial year end is 31 May. The rent for Ross’s premises is paid quarterly in advance on 1 February, 1 May,1 August and
1 November each year. The annual rent was $72,000 per year until 31 July 2008. It was increased from that date to $84,000 per
year.

What rent expense and end of year prepayment should be included in the financial statements for the year ended31 May
2009?
Expense Prepayment

A. $82,000 $14,000
B. $83,000 $7,000
C. $83,000 $14,000
D. $82,000 $7,000

Answer: Option A