Session 6 Accruals and prepayments,(3) - Tagged

Week 6: Accruals and Prepayments

Key Learning Points

  • Describe how the matching concept applies to accruals and prepayments.

  • Identify, calculate, and prepare the adjustments required for accruals.

  • Identify, calculate, and prepare the adjustments required for prepayments.

  • Accruals and prepayments in subsequent periods.

  • Identify, calculate, and prepare the adjustments required for accrued income and deferred income.

  • Identify the impact on profit and net assets of accruals and prepayments.

Introduction

  • Profit calculation relies on matching revenue earned with associated costs and expenses to calculate gross and net profit respectively.

  • The accrual basis means transactions and events are recognized when they occur, not necessarily when cash is paid or received. This aligns with the matching convention.

  • Adjustments are necessary to ensure expenses and revenues match the relevant time period:

    • Accruals: Expenses incurred but not yet recorded or paid.

Page 1: Accruals

Accruals Definition

  • Accruals reflect expenses incurred during a period but not yet recorded or paid.

Accounting Treatment

  1. Journal Entry:

    • Dr Expense account (Profit and Loss)

    • Cr Accrual liability account (Statement of Financial Position)

Example Illustration

  • Scenario: Freddie’s printing business paid a telephone bill of £3,000 on 1 January 20X8 for the period 1 October – 31 December 20X7.

    • Accounting Treatment: The expense should be included in accounts for the year ending 31 December 20X7.

    • Accrual Adjustment Journal Entry: Standard year-end adjustment needs to be made.

Page 2: Prepayments

Prepayments Definition

  • Prepayments are expenses recorded or paid for before they’ve been incurred.

Accounting Treatment

  1. Journal Entry:

    • Dr Prepayments account (Statement of Financial Position)

    • Cr Expense account (Profit and Loss)

Example Illustration

  • Scenario: Freddie paid £9,000 rent on 30 November 20X7 for the next quarter starting 1 December 20X7.

    • Accounting Treatment: Determine how much of this payment relates to the accounting period ending 31 December 20X7.

Page 3: Prepayments (Continued)

Accounting Adjustment Requirement

  • Calculate the amount of prepaid expenses that can adjust reporting at year-end.

    • Determine what amount of the £9,000 relates to future periods.

Page 4: Four-Step Approach

Adjusting for Timing Differences

Follow the four-step approach for accruals and prepayments:

  1. Reverse the opening accrual/prepayment.

  2. Post cash expenses incurred during the period.

  3. Post closing accrual/prepayment.

  4. Balance off the accounts.

Question Examples

Question 3: Electricity Payments

  • A business incurred various payments for electricity throughout the year and queries the correct accounting treatment at year-end.

Question 3 Continued

  • In the following year, similar payments need to be handled, with accrued expenses analyzed similarly.

Question 4: Acer’s Business

Electricity & Insurance Payments

Analyze cash payments for both electricity and insurance. Calculate recorded expenses and ascertain accruals/prepayments required for year-end adjustments.

Page 9: Subsequent Period Adjustments

Accruals and Prepayments Overview

  • Ensure adjustments align expenses to periods incurred:

    • Accrual: Accounts for expenses incurred before cash payment.

    • Prepayment: Defers expenses already paid for future use.

  • Any outstanding obligations must be reversed in the following period.

Page 10: Four-Step Adjustment Process

  1. Reverse opening accrual/prepayment:

    • Dr Accrual

    • Cr Expense

  2. Post cash paid during the period:

    • Dr Expense

    • Cr Cash

  3. Post closing adjustments.

  4. Balance off all accounts.

Page 11: Telephone Charges Example

Calculate expenses for telephone charges, items to consider include the reversal of accruals and adjusting cash payments made in the financial year.

Page 13: Gabriel's Gas Account

Determine the gas expense to be reported given prepayments and accrued expenses at year-end.

Impact of Accruals and Prepayments

Question 7 Analysis

Analyze the impact of recording accruals and prepayments on profit and net assets to understand how these adjustments reflect in the financial statement.

Accruals and Prepayments Principle on Income

  • Income can be accrued or deferred just as expenses are, affecting overall financial health.

Accrued Income

  • Income earned but not yet received is treated as a current asset.

Deferred Income

  • Cash received in advance of services is treated as a current liability.

Question 8: Final Adjustments Examples

  • Prepare journal entries for rent, electricity, and rental income, analyze the resultant impact on profits and net assets accordingly.