Chapter 6: Accruals and Prepayments Flashcards
6.1 Introduction
Sometimes there will be items of expenditure and income which are incurred or earned in one accounting period and paid or received in another. We would need to consider expenditure that had been consumed but not necessarily paid, for example electricity with no cash paid and hence no costs attributed to it in the profit and loss account. Similarly, you may have to pay certain expenditure in advance for a year, for example insurance.
We should show in the profit and loss account is the income and expenditure earned or incurred during a period, not necessarily that which is received or paid in cash. This is known as the accruals basis and is a concept which underlies the preparation of all accounts. Eligible small unincorporated businesses are permitted to prepare their accounts on a cash basis for tax purposes.
Accruals basis is applied in four situations:
• Expenses accrued – where expenses have been incurred but not paid for at the date to which the profit and loss is prepared
• Expenses prepaid – where expenses have been paid in advance for a period extending beyond the end of the accounting period.
• Income received in advance – where sundry income is received for a period extending beyond the end of the accounting period
• Income accrued – where sundry income has been earned but not received
The accruals basis gives rise to accounting adjustments that take place after the initial trial balance of a business has been prepared.
6.1 Introduction - expenses accrued, expenses prepaid,
Expenses accrued – where expenses have been incurred but not paid by the end of an accounting period an adjustment must be made. The adjustment will have a two-fold effect on the accounts:
• Reducing profit earned as it will increase the relevant expense in the profit and loss account
• Increasing sundry creditors (or accruals) as it will be reflected in the balance sheet under creditors falling due within one year, since the business has used goods or services for which it has not yet paid.
Making an adjustment for accrued expenses does not have any impact on cash within the business. The cash will not be impacted until the payment is made.
To achieve the desired result, we set up an accruals ledger account to record the expenses that have been incurred but not yet paid by the business or too the business. The accruals account represents a liability in the balance sheet, shown as an accrued current liability. At the start of the next accounting period, the accrued expense needs to be transferred back to the expense account from the accruals account because the outstanding expense will be paid during the next year. This reversal is often not carried out until the accounts are being prepared for the next year. In that case there will be two post trial balance adjustments, first to reverse out the opening accrual and second to set up the closing accrual.
In the instance where an accrual is an estimate of an expense (for example electricity bill), we do not go back and alter the previous year’s accrual, instead we absorb the under or over accrual in the next period.
Expenses prepaid – in this situation we have paid for an expense that relates to the following accounting period. The adjustment which needs to be made is:
• Increase profit earned by reducing the relevant expense in the profit and loss account with the amount that has been paid in advance
• Increase sundry debtors (or prepayments), by creating an asset of the same amount which will appear in the balance sheet under current assets
The necessary adjustment is made by setting up a prepayments ledger account to record the expense that has been paid but not incurred. The prepayments account represents an asset in the balance sheet.
At the start of the next accounting period, the prepaid expense needs to be transferred back to the expense account.
6.1 Introduction - income received in advance, income accrued
Income received in advance –
This mirrors the accruals above, but income received in advance is called deferred income, is disclosed as a creditor on the balance sheet. For example, if a tenant pays a landlord in advance, the cash is received before the income is earned, the landlord owes the tenant the use of the property for a period of time, so it is a creditor (deferred income) on the balance sheet. The income is then credited to the profit and loss account in the period to which it relates.
Like prepayments this will then be reversed out at the start of the next accounting period.
Accrued income – this mirrors the concept of a prepayment. It arises when income is due for the period but not yet received, for example in the case of interest receivable on a bank deposit account. The business is able to credit the profit and loss account with the income due and so create a corresponding asset called accrued income, to represent the dace that the business is owed income.
Like prepayments this will then be reversed out at the start of the next accounting period.
6.2 Accounting techniques
The steps involved in setting up the ledger accounts for the creation of accruals or prepayments can be very simply expressed as follows:
• Enter the opening balance on the expense account
• Enter the cash paid during the year
• Calculate and enter the charge due for the year, or
• Enter the closing accrual or prepayment. The other side of this double entry is taken to the accruals or prepayments ledger account
• Close the expense account and total. The missing entry will then drop out establishing either the closing accrual/prepayment or the charge for the year, depending on which step 3 was followed.
6.3 Timing of accruals and prepayments
The adjustments and prepayments are made after extracting the trial balance
Accounting entries
ADD THEM
