Chapter 2 - Accruals

Accruals Accounting

Introduction

By the end of this chapter, you should be able to understand the accruals concept, calculate accruals and prepayments, and record them in the general ledger, income statement, and balance sheet. Accruals accounting is a cornerstone of financial reporting, ensuring that financial statements provide an accurate representation of a company's financial performance and position.

In Book 2, Chapter 3, it was established that profit measures a business's ability to sell goods or services for more than the expenses incurred in producing them. Profits are determined by applying the matching principle, where income earned is matched with expenses incurred in earning that income. This chapter discusses determining all expenses incurred in generating income by applying the accruals concept and recording accruals in the appropriate accounting period. It also looks at income earned but not invoiced until after the year-end (accrued income) and income received in advance of the year-end (deferred income). The proper application of accruals accounting is essential for compliance with accounting standards like GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards).

2.1 Accruals Accounting

When preparing the income statement and determining the profit for a period, the matching concept requires that costs are matched with the revenues they help generate. This means that costs and revenues are recognized in the accounting period when they are incurred/earned rather than when the associated cash flow takes place. The goal is to present a true and fair view of the company's financial performance by aligning revenues with the expenses that helped generate them, irrespective of when the cash transactions occur.

To determine profit for the period, end-of-period adjustments have to be made to ensure that only the income earned and the expenses incurred in the process of earning that income are recorded in the income statement for the period. For example, under the accruals concept, the calculation of gross profit involves adjusting for opening and closing inventory. These adjustments ensure that the cost of goods sold accurately reflects the inventory used during the period.

Opening inventory is brought down on the inventory account from the previous period end and taken to the income statement as the opening inventory. Opening inventory ends up being an expense (debit in the income statement) because it is used up in the period. Closing inventory is a deduction (credit) in the income statements and a current asset (debit) in the balance sheet because it still exists at the year-end. This ensures that the income statement only reflects the cost of goods actually sold during the period, while the balance sheet reflects the value of unsold inventory.

Steps to record inventory account:

1. Credit the inventory account and debit the income statement with the amount of the balance brought down. This recognizes the beginning inventory as an expense for the current period.

2. Carry down and bring down the closing balance. This ensures that the closing inventory is accurately reflected in the accounting records.

3. Take the closing inventory to the income statement. Debit the inventory account and credit the income statement. This adjustment removes the value of the closing inventory from the cost of goods sold.

4. Enter the totals.

Example: Writing up the inventory account

The balance on the account of £1,220 at 31 March 20X3 is brought down from the previous year as a debit to the year commencing 1 April 20X3.

Inventory

The £1,220 is then debited to the income statement and credited to the inventory account:

Inventory

The closing inventory of £1,940 at 31 March 20X4 is debited to the inventory account and credited to the income statement:

Inventory

The balance on the account of £1,940 at 31 March is carried down from 20X4 (credit) and brought down to 1 April 20X4 (debit). It will be shown as an asset in the balance sheet:

Inventory

The effect on the income statement can be seen in Activity 2.1.

Stop and reflect:

If a business has increased its cash, has it also increased its profit? Profit need not be related to the increase in cash generated in a period, and it is possible for a business to make a significant loss in a period but experience a dramatic increase in cash. On the other hand, it is also possible for a business to make a significant profit in a period but experience a dramatic fall in cash. Understanding the difference between profit and cash flow is crucial for effective financial management. Profit reflects the overall performance of the business, while cash flow indicates its liquidity and ability to meet short-term obligations.

What many people do not realize is that if it does not have enough cash, a highly profitable business can become insolvent, a situation that occurs when a business cannot pay liabilities when they fall due because of a shortage of cash. One of the reasons why profit and cash will differ is due to the application of the accruals concept. Accruals accounting recognizes revenues and expenses when they are earned or incurred, not when cash changes hands, leading to discrepancies between reported profit and actual cash flow.

Activity 2.1 End-of-period adjustment

Charlie's DVDs is a small cash-only business that buys and sells DVDs. In its accounting year ending 31 March 20X4, the business sold DVDs to the value of £22,400. At the beginning of the year, Charlie's DVDs had an opening inventory of DVDs that was valued at £1,220, and the business made new purchases of DVDs in the course of the accounting year that cost £9,680. At the end of March 20X4, Charlie's DVDs had a closing inventory of DVDs valued at £1,940. Using the accruals method of accounting:

• Calculate Charlie's gross profit for the period using the recommended format. Refer back to Book 2 Section 3.3 for the format if you have forgotten it. Gross profit is calculated as revenue less cost of goods sold (COGS). In this case, revenue is £22,400, and COGS needs to be calculated by adjusting purchases for opening and closing inventory.

• Explain why an end-of-period adjustment to purchases, to reflect that there is closing inventory, is necessary in Charlie's accounts. The adjustment is necessary to ensure that the cost of goods sold only includes the cost of DVDs actually sold during the period, not the cost of all DVDs purchased.

Other than adjusting for closing inventory, the other main types of end-of-period adjustments needed to determine the income earned and revenue expenses incurred during the relevant accounting period are for:

• accruals (accrued expenses). Accrued expenses are expenses that have been incurred but not yet paid.

• prepayments (expenses paid in advance). Prepayments are expenses that have been paid but not yet incurred.

• accrued income (income that has been earned in the year but not received in the year). Accrued income is revenue that has been earned but not yet received.

• income received in advance (income received in the year that relates to a subsequent period). This is also known as deferred revenue.

• depreciation of non-current assets (covered in Chapter 3). Depreciation is the allocation of the cost of an asset over its useful life.

• irrecoverable receivables (covered in Chapter 4). Irrecoverable receivables are amounts owed to the business that are not expected to be collected.

• an increase or decrease in allowance for irrecoverable receivables (covered in Chapter 4). This allowance is used to estimate the amount of receivables that may not be collected.

2.2 Accruals

A very common adjustment that needs to be made when preparing an income statement for a period is to recognize accrued expenses, commonly known as accruals. These are expenses that have been incurred in a period but have not been paid or recorded in the accounts. Accruals are essential for accurately reflecting the financial obligations of a company at the end of an accounting period.

Usually, when a business purchases goods and services, they are ordered in advance and invoiced when delivered. The invoice is recorded in the accounts, and the item is treated as an asset or an expense. However, for some regular transactions, the quantities are not ordered in advance and are invoiced after they have been consumed. Typical examples of these expenses are telephone, heating and lighting, and professional fees. These types of expenses often require accrual adjustments to ensure they are recognized in the correct accounting period.

In many countries, telephone and power supplies are usually invoiced every three months and reflect the consumption for the previous three months. This situation means that an expense is going to be invoiced after the period to which it relates. This is the expense that needs to be 'accrued'; that is, it needs to be recorded in the period to which it relates. Accruing these expenses ensures that the income statement accurately reflects all costs associated with generating revenue during the period.

Example: Accrued expense

Suppose that Duncan pays a quarterly electricity charge for the periods November to January, February to April, May to July, and August to October. Assuming the accounting year follows the calendar year, this would mean that at 31 December 20X1, the business would have received and possibly paid the electricity bill (invoice) for the August–October quarter, but Duncan would not have accounted for any electricity expense for November and December. Following the accruals concept, the electricity charge for November and December must be an expense for that year. This is an accrual or accrued expense incurred but not invoiced or paid. Without this accrual, the financial statements would understate expenses and overstate profit for the year.

The timeline in Figure 2.1 below shows clearly the two months (November and December) when the electricity expense needs to be accrued for the accounting period from 1 January 20X1 to 31 December 20X1.

Figure 2.1 Electricity invoice timeline

2.2.1 Accounting for the accrued expense

An adjustment is needed in the situation above to follow the accruals concept and to record the accrued expense in the accounts. In the case of the electricity expense for November and December above, Duncan would need to estimate the expense for these two months, given the actual expense is only revealed when the invoice is received in February. One way of doing this is to base it on the invoice for the same period in the previous year. Say the invoice for the period November 20X0 to January 20X1 was £3,600. Duncan should consider whether this year's invoice will be any larger or smaller as a result of events known about or as a result of the general trend of electricity prices. He can make an estimate of the electricity accrual needed. This estimate should be based on the best available information and professional judgment to ensure accuracy.

Example: Treatment of accruals

Duncan expects the cost of electricity to rise by 10% or more:

$3,600 + 10\% = 3,960$

The invoice covered three months, and Duncan only wants to estimate the accrual for the two months November–December 20X1

$(2/3 \times £3,960 = £2,640)$

He can then adjust for the estimated accrual of £2,640. This adjustment ensures that the financial statements accurately reflect the expenses incurred during the accounting period.

Duncan now needs to recognize this in the general ledger of his business, i.e., increase the electricity expense by £2,640 and show an outstanding liability of £2,640. The adjustment needed for the estimated electricity expense for 1 November 20X1 to 31 December 20X1 would be:

Dr Electricity expenses Nov–Dec £2,640

Cr Accrued expenses £2,640

The accrued electricity expenses are included in the income statement as part of the heating and lighting expense and included in the balance sheet under current liabilities. This reflects the fact that the expense has been incurred but not yet paid, creating a liability for the business.

Figure 2.2 shows how the accrual is accounted for in the financial statements. In the diagram, the total payments made in the year to 31/10/20X1 for electricity total £9,420.

Figure 2.2 Treatment of accruals

The accrual would be reflected in the general ledger:

Heating and lighting (expense)

*There is an existing balance in the heating and lighting account for the period 1/1/20X1 to 31/10/20X1 as this is a known figure based on invoices that have already been received from the power company.

Accruals (liability)*

• If it does not already have one, the business will normally open a new general ledger account, called accruals. This is a liability account, reflecting that at 31 December 20X1 the business owes an estimated £2,640 for electricity consumed but not yet invoiced. At the end of the accounting year, the balance on this account is normally recorded after payables under the sub-heading 'current liabilities' in the balance sheet. This account helps track all accrued expenses and ensures they are properly disclosed in the financial statements.

The effect of this adjustment is to increase the expense for heating and lighting that is taken to the income statement and also to create a short-term liability that will be included in current liabilities. In this way, the income statement reflects all the heating and lighting expenses for the year ending 31 December 20X1, and the balance sheet as at the 31 December 20X1 acknowledges that there is a liability for unpaid electricity.

Something to remember

Always remember the AA lesson – to Add Accruals to expenses. This simple reminder can help ensure that accrued expenses are properly accounted for in the financial statements.

2.2.2 Accounting for the accrued expense in the following accounting year

At the beginning of the following year, when the invoice is received, it is debited to the relevant expense account. The accruals concept tells us that the accrued expense should not be included in the accounts for the new accounting period because it has already been recognized as an expense in the previous period. It is not correct to record the same expense twice in the accounts! The accounting entry needed is to debit the accrued expenses account and credit the relevant expense account. A good way of remembering this double entry is to realize that the relevant expense account should at this stage be credited with the expense that it has already recognized, i.e., the accrual needs to be reversed. This reversal ensures that the expense is not double-counted and that the financial statements remain accurate.

Activity 2.2 Accrued expenses

Duncan now needs to start his bookkeeping for the year ending 31 December 20X2. Complete the double entries for the accrued expense in Duncan's business above at the beginning of the next accounting period ending 31 December 20X2.

Heating and lighting (expense)

Accrued expenses (liability)

The following activity deals with the account process for the invoice for the heating and lighting when it arrives in the course of 20X2.

Activity 2.3 Effect of an incorrect estimate

Continuing on from Activity 2.2, the business was expecting an invoice of £3,960 from the power company in 20X2 covering the period 1 November 20X1 to 31 January 20X2. The expected figure of £3,960 comprised an estimate of £2,640 which was accrued for the year ending 20X1 and the estimated cost for January 20X2. Instead, the business received an invoice in February 20X2 for £4,000 from the power company for electricity consumed over the three months in question.

• Complete the double entries for the receipt of the invoice.

• Explain the effect of the incorrect estimate of the heating and lighting expense on the business's accounts. An incorrect estimate can lead to either an overstatement or understatement of expenses in the financial statements. This can affect the accuracy of reported profit and may require adjustments in subsequent periods.

The following example explains how to account for accrued expenses in the general ledger.

Example: Accounting for accrued expenses in the general ledger

Later in the year, the above business receives the following invoices:

The business pays its invoices on the last day of each month. At the business year-end of 31 December, it is estimated that the accrual for heating and lighting covering the period 1 November 20X2 to 31 December 20X2 will be £2,800. The general ledger accounts at 31 December are shown below:

Heating and lighting (expense)

*This is the difference between the total debits and the credits posted to the account. It is, therefore, the charge for heating and lighting that will be shown in the income statement at the year ending 31 December 20X2.

Power company (liability)

Accrued expenses (liability)

At the financial year-end of 31 December 20X2, the heating and lighting expenses in the income statement are £14,610. The power company's invoices have all been paid, and the balance on the accrued expenses account is £2,800. This accrual will appear in the balance sheet under current liabilities. This ensures that the financial statements accurately reflect the company's financial position and performance.

Stop and reflect

What are accruals?

Accruals are where we have to deal with items of expenditure paid after the end of the accounting period, part or all of which belong to the accounting period. Debit the expense account and credit the accrued expenses account. Accruals help to match expenses with the revenues they generate, providing a more accurate picture of a company's profitability during a specific period.

A business normally has a number of accrued expenses that occur every year, and these are normally all removed from the accrued expenses account in one block at the beginning of the following year by debiting the accrued expenses account and crediting the relevant expense accounts. This is known as reversing out the entries. Reversing entries simplify bookkeeping and ensure that expenses are not double-counted in subsequent periods.

Activity 2.4 Calculating charges and accruals

Imagine that your accounting period ends on 30 June 20X1 and that the administrative expenses of your business normally include the telephone bill. In August 20X1 you pay the quarterly bill of £900 for the months May, June, and July. What are the charges and/or accruals for each of the two accounting periods, ending 30 June 20X1 and 30 June 20X2, with respect to this bill? Rather than show the general ledger accounts, show a working and then state which account should be debited and which credited for the year ending 30 June 20X1. Your working could be in the format of a timeline. This exercise helps to understand how expenses are allocated between different accounting periods.

Activity 2.5 Applying accruals

A business with a financial year-end 30 June pays machinery rental, which is due for payment every three months. The quarterly charge is £300.

Prepare the machinery rental account for the year ended 30 June 20X2. This activity provides practical application of accruals accounting in the context of machinery rental expenses.

2.3 Prepayments

The opposite situation to accrued expenses arises when the business pays in advance for goods or services, known as a prepayment. This happens routinely for transactions such as rental of premises or equipment and insurance. The accruals concept applies just the same. For example, rent may be payable quarterly in advance. This would mean that rent for the period January to March would be payable by the end of December the previous year. This means that the business has paid in one year an expense that belongs in the income statement for the following year. Prepayments must be recognized to align expenses with the periods they benefit, ensuring accurate financial reporting.

The timeline in Figure 2.3 below shows clearly how a rent invoice for the next accounting period – 1 January 20X2 to 31 December 20X2 – is received and paid for in the previous accounting period – 1 January 20X1 to 31 December 20X1.

Figure 2.3 Rent invoice timeline

This payment in December 20X1, covering the period 1 January 20X2 to 31 March 20X2, is called a prepayment (or a prepaid expense). It is treated with the same logic as accrued expenses, i.e., use the accruals principle to match the expenditure to the relevant accounting period. At the time the business makes the payment (e.g., rent), it is, in effect, purchasing an asset, i.e., a right to use the rented premises for the next three months. This asset will only start being used up in the next accounting period. By recognizing prepayments, businesses can avoid overstating expenses in the current period and understating them in future periods.

Activity 2.6 Prepayments

A small business had a financial year that ended on 31 December 20X1. At 31 December 20X1, the business had paid five quarterly rent payments of £4,000 each. The last payment covered the quarter for January 20X2 to March 20X2. Prepare the rent account and the prepayment account for the year ending 31 December 20X1. Remember to close each account and bring the balance down on the prepayment account. This exercise helps illustrate the practical steps involved in accounting for prepayments.

Something to remember

Remember the RE rule – to REduce expenses by pREpayments.

Or you may prefer The MP lesson – Minus Prepayments from expenses.

On the first day of a new accounting period, the prepayment will need to be reversed so that it becomes part of the charge (expense) of the current year. The accounting entries are:

Debit: The appropriate expense account

Credit: Prepayment account

Activity 2.7 Reversal of a prepayment

Following on from Activity 2.6, it is now 1 January 20X2. Reverse the prepayment ready for writing up the general ledger for the year ended 20X2. This activity provides a clear demonstration of how to reverse a prepayment at the beginning of a new accounting period.

Activity 2.7 on prepayments above was straightforward because the expense payment referred entirely to the following accounting year. In the next activity, you will need to use your knowledge of the accruals concept to allocate the payment of an expense over two accounting periods.

Reminder:

Prepayments are items of expenditure made during an accounting period that belong to a future accounting period.

Activity 2.8 Making adjustments

Imagine that your accounting period ends on 30 June 20X1 and an insurance premium of £900 is included in your expenses. You paid this premium on 1 January 20X1, and it covers insurance for the year ending 31 December 20X1. Calculate the adjustments that would need to be made at the end of the accounting period. Rather than show the general ledger accounts, show a working and then state which account should be debited and which credited. You may find the use of a timeline helpful here. This exercise requires allocating an insurance expense over two accounting periods.

The prepayment for insurance is excluded from the income statement and included in the balance sheet under current assets. This reflects the fact that the business has paid for insurance coverage that will benefit future periods.

Figure 2.4 below shows how a prepayment is accounted for in the financial statements. The '£400 charge 1 July 20X0 to 31 December 20X0' is last year's prepayment that relates to the first six months of 20X1 but which was paid in last year's accounts.

Figure 2.4 Treatment of prepayments

The following will give you practice in accounting for prepayments. When you reach Unit 5, you should be pleased that you undertook this practice. Mastering prepayments is essential for preparing accurate financial statements and understanding a company's true financial position.

Activity 2.9 Accounting for prepayments

A small business had a financial year that ended on 31 December 20X5. The business bought a delivery truck on 1 August 20X5 and paid £1,800 the same day to insure the truck for the following 12 months. Complete the double entries in the general ledger for the following:

• insurance payment on 1 August 20X5

• adjustment required to reflect the prepayment at the year-end

• reversal of the prepayment at the beginning of the next financial year.

Activity 2.10 Accruals and prepayments

Jefferson runs a business. During the year ending 31 December 20X1, he made the following payments:

£

Electricity 6,800

Insurance 2,600

At 31 December’20X0, his accruals and prepayments were:

Electricity Accrual £800

Insurance Prepayment £600

At 31 December 20X1, his accruals and prepayments were:

Electricity Accrual £1,000

Insurance Prepayment £700

Calculate the income statement charges for electricity and insurance that will appear in the 31 December 20X1 financial statements, and prepare the electricity and insurance general ledger accounts. The way to answer this question is:

Step 1 Open up the electricity account and the insurance account.

Step 2 Post the opening balances (accrual and prepayment).

Step 3 Post the payments.

Step 4 Post the closing balances (accrual and prepayment).

Step 5 Balance the account and enter the income statement figure