Chapter 6: Cost of sales, accruals, and prepayments

Question 1

1.1 Opening and closing inventory

Answer 1

The financial statements account for any goods held at the end of the year (closing inventory). These are goods which have been purchased but not sold, they are not part of cost of goods sold, they are a current asset of the business. The correct double entry to record closing inventory is:
- Dr Closing inventory (statement of financial position)
- Cr Closing inventory (cost of sales on statement of profit or loss)
Opening inventory is the closing inventory from the previous period, is part of this period’s cost of sales (as it should be sold) and is therefore added to purchases.

Question 2

1.2 Delivery inwards and outwards

Answer 2

Delivery inwards is the amount paid by a business for having the goods delivered to it, the cost is part of costs of sales in the statement of profit or loss. Delivery outwards is the amount paid by a business for delivering goods to its customers, the cost is an expense in the statement of profit or loss.

Question 3

2.1 Accruals basis of accounting (prepayments)

Answer 3

The accruals basis means to calculate the profit for the period we include all income and expenditure relating to the period, whether or not cash has been exchanged. Income is matched with the expenditure incurred to generate that income in a particular accounting period – the matching concept.
Accruals and prepayments in the accounts arise from a year end adjustment cause by the accruals concept as we ensure that the correct expense figure is included. It may be necessary to make an adjustment if cash paid for expenses in the period does not equal expenses relating to the period.
If you have incurred an expense and not paid for it at year end, you need to record an extra expense at year end by making an accrual: Dr expense (SPL), Cr Accruals (SFP).
If you have paid for an expense in advance, you need to reduce the expense at the year-end by making a prepayment: Dr Prepayments (SFP), Cr Expense (SPL).

Question 4

2.2 Accruals

Answer 4

To deal with accruals, record any cash paid during the year in the expense ledger, calculate whether a closing accrual is required: Dr Expense, Cr accruals.
Close off the expense ledger by taking the balance to the trail balance and then the statement of profit or loss. Then close off the accruals ledger by taking the balance to the trail balance and then to current liabilities in the statement of financial position.
Opening and closing accruals
A year end accrual becomes the opening balance of the next period, this opening balance needs reversing at the start of the next period. The steps are:
- Bring in the brought forward opening balance on the accruals ledger (credit side as accruals are liabilities)
- Reverse out the opening accrual: Dr Accruals Cr Expense
- Record any cash paid during the year in the expense ledger: Dr Expense Cr Cash
- Calculate whether a closing accrual is required: Dr Expense Cr Accruals
- Close off the expense ledger: take the balance to the trail balance and then the statement of profit or loss
- Close off the accruals ledger: take the balance to the trial balance and then to current liabilities in the statement of financial position

Question 5

2.4 Prepayments

Answer 5

The following steps should be used to deal with a prepayment:
- Bring in the brought forward opening balance on the prepayments ledger (debit side as prepayments are assets)
- Reverse out the opening prepayment: Dr Expense Cr Prepayments
- Record any cash paid during the year in the expense ledger: Dr Expense Cr Cash
- Calculate whether a closing prepayment is required Dr Prepayments Cr Expense
- Close off the expense ledger: take the balance to the trial balance and then the statement of profit or loss
- Close off the prepayments ledger: take the balance to the trail balance and then to current assets in the statement of financial position

Question 6

2.5 Accrued income and deferred income

Answer 6

Accrued income and deferred income in the accounts arise from a year end adjustment caused by the accruals concept as we need to ensure that the correct income figure has been included in the statement of profit or loss.
Deferred income is income received in advance that relates to the next period, this needs to be removed from the statement of profit or loss. Dr Income (SPL) Cr Deferred income (SFP)
Accrued income is income earned during the period but not yet received, this needs to be included in the statement of profit or loss. Dr Accrued income (SFP) Cr Income (SPL).
The following steps should be used to deal with accrued income:
- Bring in the brought forward opening balance on the accrued income ledger (debit side as accrued income is an asset)
- Reverse out the opening accrued income: Dr Income Cr Accrued income
- Record any cash receive during the year in the income ledger: Dr Cash Cr Income
- Calculate whether a closing accrued income adjustment is required: Dr Accrued income Cr Income
- Close off the income ledger: take the balance to the trial balance and then the statement of profit or loss
- Close off the accrued income ledger: take the balance to the trial balance and then to current assets in the statement of financial position

Question 7

2.6 Deferred income

Answer 7

The following steps should be used in order to deal with deferred income:
- Bring in the brought forward opening balance on the deferred income ledger (credit side as deferred income is a liability)
- Reverse out the opening deferred income: Dr deferred income Cr income
- Record any cash received during the year in the income ledger: Dr Cash Cr Income
- Calculate whether a closing deferred income adjustment is required: Dr Income Cr Deferred income
- Close off the income ledger: take the balance to the trial balance and then the statement of profit or loss
- Close off the deferred income ledger: take the balance to the trial balance and then to current liabilities in the statement of financial position