Chapter 9 - Accruals and prepayments

Question 1

What is the accruals principle?

Answer 1

The accruals principle also requires that expenses are matched to the period to which they relate, not when they were paid.

We use the accrual principle to match the expense to the relevant time period. This creates accruals and prepayments in the statement of financial position.

Question 2

What is an accrual? What is the journal entry?

Answer 2

A liability for expenses to be charged against a particular period even though they have not been paid for
e.g. outstanding phone bill as at 31.12.X1
Dr Expense (profit or loss)
Cr Accruals (a liability in SOFP)

This would be how we post our closing accrual

To calculate accrual value it would be the amount we have not paid in that financial year
e.g. tel exp is 300 for 1nov-31jan, we won’t be getting invoiced till jan, we calculate 2/3rd of the price so 300x2/3 = 200. Times by 2 as 2 months. This is our accrual figure.

Question 3

What is a prepayment? What is the journal entry?

Answer 3

As asset relating to expenses that have been paid in one period but are not charged to the profit or loss until a later period to which they relate.

eg rent paid for in advance

Dr Prepayments (an asset in the SOFP)
Cr Expense (profit or loss)

Question 4

At the start of a year what do we need to do to our accruals and prepayments?

What are the 3 general steps

Answer 4

We have seen the required double entries for accounting for accrued and prepaid expenses at the year end.
These must then be reversed by an opening journal in the new period to ensure the expenses are correctly matched to the appropriate reporting period.

Step 1: Reverse opening accruals and prepayments
Step 2: Post cash payments to the relevant expense ledger
Step 3: Calculate and post closing accruals and prepayments

Question 5

What is the journal we want to use at the start of a year for an accrual?

Answer 5

We need to reverse the opening

Dr Accruals (SOFP)
Cr Expense (profit or loss)

Question 6

What is the journal to post our closing accrual?

Answer 6

Dr Expense (profit or loss)
Cr Accruals (a liability in SOFP)

This would be how we post our closing accrual

Question 7

What is the journal we want to use at the start of a year for an prepayment?

Answer 7

Reverse opening prepayment
Dr Expense (profit or loss)
Cr Prepayment (SOFP)

Question 8

Exam Tip
Questions that give information regarding opening or closing accruals or prepayments are usually best tackled using ledger (T) accounts and the 3 step approach.
If there is no information on opening or closing balances, a simple timeline and logic is often quicker.

Answer 8

Exam Tip
Questions that give information regarding opening or closing accruals or prepayments are usually best tackled using ledger (T) accounts and the 3 step approach.
If there is no information on opening or closing balances, a simple timeline and logic is often quicker.

Question 9

What is Accrued Income? What is the journal entry?

Answer 9

Receipt of income is in arrears (after earned it) at the year and
(income is outstanding) so I am missing income for the last few months of the year

the accrued income account is similar to the trade receivables account (so I am owed this money) therefore it is a CURRENT ASSET as I am OWED £

Dr Accrued income (an asset in the SoFP)
Cr Revenue/other income (SALES)

Question 10

When you think of ARREARS what should we think of? What is the journal to match this?

Answer 10

ARREARS = ACCRUED INCOME

Dr Accrued income (an asset in the SoFP)
Cr Revenue/other income (SALES)

Question 11

What is Deferred Income? What is the journal entry?

Answer 11

Deferred Income = PREPAID INCOME

Income has been received in advance of delivering the goods or services. We owe a service. e.g. paid rent early so we owe the service

Dr Revenue/other income
Cr Deferred income (a liability in the SoFP)

Question 12

At the start of a year what do we need to do to our accrued income and prepaid/deferred income?

What are the 3 general steps

Answer 12

Step 1: Reverse opening accrued or deferred income
Step 2: Post cash received in the normal way
Step 3: Calculate and post the closing accrued or deferred income

This idea commonly examined in relation to rental incomes and subscription income, for which it is useful to use a “Subscriptions/Rent receivables” account (similar to a trade receivables account) - OTHER INCOME ACCOUNT

Question 13

What happens if you forget to record an accrual?

Answer 13

Expense is understated: By not recording the accrual for the electricity bill, the expense for that period (December, in this case) is understated because the cost incurred hasn’t been reflected.

Profit is overstated: Since the expense wasn’t recognized, your profit (or net income) for that period will appear higher than it should be because fewer expenses are being deducted from the revenue.

Liabilities are understated: Without the accrual entry, you have not recognized the amount you owe (the liability), so your liabilities will be understated on the balance sheet.

Question 14

What happens if you forget to record a prepayment?

Answer 14

Expenses are overstated: Since you don’t split the cost over future periods, the entire payment is treated as an expense in the current period, making your expenses too high.

Assets are understated: Prepayments are assets (future benefits), so by not recording them, you’re missing an asset on your balance sheet.

Liabilities are not affected: Prepayments don’t impact liabilities, as they relate to expenses paid in advance, not amounts owed.

Profit is understated: Because your expenses are overstated, your profit (or net income) is lower than it should be.

Question 15

How does Accrued Income affect
Assets
Liabilities
Expenses
Profit

Answer 15

Assets: Increase (due to accrued income).
Liabilities: No effect.
Expenses: No effect.
Profits: Increase (due to higher recognized revenue).

Accrued income has specific effects on financial statements. Here’s how it impacts assets, liabilities, expenses, and profits:

1. Assets:
   Increase: Accrued income is recorded as an asset because it represents amounts owed to the company for services rendered or goods delivered that have not yet been paid for. This means your total assets increase.
2. Liabilities:
   No effect: Accrued income does not impact liabilities. It’s an asset account, reflecting money owed to you, rather than a liability you owe to someone else.
3. Expenses:
   No effect: Accrued income does not directly affect expenses. It is related to revenue recognition and does not change your expense accounts.
4. Profits:
   Increase: By recognizing accrued income, you increase your revenue for the period. Since profits are calculated as revenue minus expenses, higher revenue from accrued income will lead to higher profits for that period.

Question 16

How does Deferred Income affect
Assets
Liabilities
Expenses
Profit

Answer 16

Assets: No effect.
Liabilities: Increase (due to the obligation created by deferred income).
Expenses: No direct effect.
Profits: No immediate effect; profits increase when the deferred income is recognized as revenue upon service delivery.

Deferred income affects financial statements in specific ways. Here’s how it impacts assets, liabilities, expenses, and profits:

1. Assets:
   No effect: Deferred income does not directly affect assets. It represents cash received for services not yet performed, so it’s recorded as a liability instead of increasing asset balances.
2. Liabilities:
   Increase: Deferred income is recorded as a liability because it represents an obligation to deliver goods or services in the future. When you receive payment in advance, you recognize it as deferred income, increasing total liabilities.
3. Expenses:
   No direct effect: Deferred income itself does not impact expense accounts. However, as you deliver the services related to the deferred income, you may incur expenses that could affect profits in the future.
4. Profits:
   No immediate effect: When deferred income is recognized, it does not immediately affect profits. Profits will only be impacted when the service is delivered, and the deferred income is recognized as revenue. At that point, it will increase revenue and, potentially, profits.

Question 17

How does Prepayments affect
Assets
Liabilities
Expenses
Profit

Answer 17

Assets: Increase (prepayments are recorded as assets).
Liabilities: No effect.
Expenses: No immediate effect (recognized over time).
Profits: No immediate effect; profits will be affected as expenses are recognized.

Prepayments have specific effects on financial statements. Here’s how they impact assets, liabilities, expenses, and profits:

1. Assets:
   Increase: Prepayments are recorded as assets because they represent future economic benefits. For example, if you pay for an annual insurance policy upfront, that amount is recognized as a prepaid expense (an asset) on the balance sheet.
2. Liabilities:
   No effect: Prepayments do not directly affect liabilities. They represent amounts paid in advance for goods or services that will be received in the future, not obligations owed.
3. Expenses:
   No immediate effect: When you make a prepayment, you do not immediately recognize it as an expense. Instead, you recognize the expense gradually as you consume the prepaid service or benefit over time. For instance, if you prepay rent, you’ll recognize it as an expense month by month as the rental period elapses.
4. Profits:
   No immediate effect: Prepayments do not affect profits at the time of payment. Profit will be affected when the prepayment is recognized as an expense in the income statement. Until the expense is recognized, profits remain unchanged.

Assets: Increase (prepayments are recorded as assets).
Liabilities: No effect.
Expenses: No immediate effect (recognized over time).
Profits: No immediate effect; profits will be affected as expenses are recognized.

Question 18

How does Accruals affect
Assets
Liabilities
Expenses
Profit

Answer 18

Assets: Increase (due to accrued income).
Liabilities: Increase (due to accrued expenses).
Expenses: Increase (when recording accrued expenses).
Profits: Decrease (due to higher expenses) or Increase (due to recognized accrued income).

Accruals have significant effects on financial statements. Here’s how they impact assets, liabilities, expenses, and profits:

1. Assets:
   Increase: When you record accrued income (revenue earned but not yet received), it increases your assets. For example, if you complete a service worth £4,000 but haven’t invoiced the client, you would record this as an accrued income asset.
2. Liabilities:
   Increase: If you record an accrual for an expense (like an unpaid bill), it increases your liabilities. For example, if you owe £500 for services received but haven’t paid yet, this creates an accrual liability.
3. Expenses:
   Increase: When you recognize an accrued expense, it increases your expenses in the income statement. For instance, recognizing a £500 electricity bill that hasn’t been paid yet will increase your expenses for that period.
4. Profits:
   Decrease: When you recognize accrued expenses, your profits decrease because higher expenses reduce net income. Conversely, recognizing accrued income increases profits because it adds to revenue.