CHAPTER 10
ACCRUALS AND PREPAYMENTS
ACCRUAL BASIS OF ACCOUNTING:
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.
It is sometimes known as matching concept.
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
ACCURED EXPENDITURE:
Accrued expenditure is an expense relating to a particular period but not yet paid.
In this case, it is necessary to record the extra expense relevant to the year and
create a corresponding statement of financial position liability.
Dr Expense account X
Cr Accrual /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 EXPENDITURE:
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 Prepayment 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
PROFORMA EXPENSE T-ACCOUNT:
Expense
Balance b/f (opening prepaid expense) X Balance b/f (opening accrued expense) X
Bank /cash (total paid during the year) X Profit or loss (total expense for the year)X
Balance c/f (closing accrued expense) X Balance c/f (closing prepaid expense) X
X X
ACCURED INCOME:
Accrued income arises where income has been earned in the accounting period but
has not yet been received.
Accrued income creates an additional current asset on our Statement of financial
position.
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
E.g. Bank interest received .
Accrued income is a current asset in the statement of financial position.
PREPAID INCOME:(pre received income , Deferred income )
Prepaid income arises where income has been received in the accounting period
but which relates to the next accounting period.
Prepaid income reduces income on the Statement of profit or loss and hence
reduces overall profits too. It also creates a current liability on our Statement of
financial position.
Dr Income (P/L) X
Cr Prepaid Income (SOFP) X
PROFORMA INCOME T-ACCOUNT:
Income
Balance b/f (opening accrued income) X Balance b/f (opening prepaid income) X
Profit or loss (total revenue for the year)X Cash (total received during the year) X
Balance c/f (closing prepaid income) X Balance c/f (closing accrued income) X
X X
EFFECT OF ACCRUEL & PREPAYMENT:
Expense/Income Profit Asset/Liability
Accrued expenses ↑ exp ↓ ↑ liability
Accrued income ↑ inc ↑ ↑ asset
Prepaid expense ↓ exp ↑ ↑ asset
Prepaid income ↓ inc ↓ ↑ liability
Example:
A business’ electricity charges amount to $12,000 pa. In the year to 31December
20X5, $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?
Show the relevant entries in the ledger accounts.
Solution:
The total expense charged to the statement of profit or loss in respect of
electricity should be $12,000.
The year-end accrual is the $3,000 expense that has not been paid in cash.
The double entry required is:
Dr Electricity expense $3,000
Cr Accruals $3,000
Ledger accounts and accrued expenses
Method 1: know the accrual
Electricity expense
$ $
Cash Profit or loss
9,000 12,000
Accrual c/f
3,000 12,000
12,000 Accrual b/f 3,000
Method 2: know the statement of
profit or loss charge
Electricity expense
$ $
Cash Profit or loss
9,000 12,000
Accrual c/f
3,000 12,000
12,000 Accrual b/f 3,000
