Chapter 9: Accruals, Prepayments, Accrued and Deferred Income Flashcards
The ACCRUALS CONCEPT principle states that all income earned and expenses incurred should be recognised in the period to which they relate, irrespective of whether the cash has been received or paid.
This Accruals concept means that the income and expenses of a business should be matched to the period in which they were earned (income) or incurred (costs), not on a cash basis.
We have learnt that Accruals Concept is applied to:
RECEIVABLES AND PAYABLES
· When goods are sold or bought on credit, the sale or the purchase is recorded immediately, and receivables and payables are created. The income (Sales) and expense (Purchases) is recognised even though there has been no actual payment.
BUSINESS EXPENSES AND INCOME
· The same logic used for credit sales and purchase transactions is applied to other expenses or income of the business, such as rental, electricity and insurance fees.
Applying the Accruals Concept to Accruals, Prepayments, Accrued Income and Deferred Income
Payment received from income and made for expenses may be made in arrears (received/paid later) or in advance (received/paid earlier).
[see table]
Accruals -> expenses incurred before payment made -> liability -> Dr expenses, Cr accruals
Prepayments -> Payment made before expenses incurred -> asset -> Dr Prepayments, Cr Expenses
Accrued Income -> income earned before payment received -> Asset -> Dr Accrued income Cr Income
Deferred Income -> payment received before income earned -> liability -> Dr Income, Cr Deferred Income
A business may incur expenses with payments made in arrears or in advance:
- ACCRUALS are EXPENSES PAID IN ARREARS. For example electricity used from January to March is only paid for at the end of March. Accruals are reported as a LIABILITY in the Statement of Financial Position.
- PREPAYMENTS are EXPENSES PAID IN ADVANCE. for example, yearly business insurance is paid once at the start of the year. Prepayments are reported as an ASSET in the Statement of Financial Position
Examples of business expenses include wages, electricity, repairs, maintenance, telephone, insurance, rental of shops, advertising, stationery, and interest on borrowings.
Expenses can be split into two categories:
- Expenses that relate to a specific transaction on a particular date, such as stationery and repairs expense
- Expenses relating to an ongoing service such as electricity, rental and telephone expenses.
For example, a business uses electricity daily and therefore incurs electricity expenses. The business only receives invoices and pays the electricity expense after the period of use (e.g. end of every 3 months).
At the year-end, Sunrise Lighting owes the supplier for electricity supply that has yet to be invoiced. The expense incurred during the year that has not been paid will need to be accrued. This ensures that the total cost of the electricity the business uses in the year is reflected in the final accounts.
- The business expense reflected in the final accounts should be based on the electricity use, not how much has been invoiced or paid.
A business may generate income with payments received in arrears or in advance:
- ACCRUED INCOME is INCOME GENERATED FOR PAYMENTS RECEIVED IN ARREARS. for example, a business may rent out additional space in an office and collect rental income at the end of the month. Accrued income is reported as an ASSET in the Statement of Financial Position
DEFERRED INCOME is INCOME GENERATED WITH PAYMENTS RECEIVED IN ADVANCE
For example, a business may collect rental income only at the end of the month. Deferred income is reported as a LIABILITY in the Statement of Financial Position
- An Accrual is recognised when an expense incurred during the financial period has not been paid by the end of the financial period
A business recognises an expense when it receives a purchase invoice (DR Expenses, CR Payables/Bank). However, ongoing expenses may only be paid after the services have been incurred. This is known as a payment IN ARREARS. The expense incurred that has not been paid is recognised as an accrual.
For example, Sunrise Lighting’s electricity supplier sends their quarterly invoice in arrears (3 months). This means that Sunrise Lighting pays the supplier three months after it has used the electricity.
At the year-end, Sunrise Lighting will owe the electricity supplier for electricity used that has not been paid. An accrual (liability) is therefore needed to record the expense.
If Sunrise Lighting recorded the expense based on its cash payments, expenses would be understated as Sunrise Lighting has used more electricity than has been paid for. Therefore, Sunrise Lighting should increase its expense recognition by the accrual value.
Accounting Entries for Accruals
Once the accrual amount is established, the amount is recognised as an expense and a liability.
At year-end, the business will CREATE ACCRUALS for expenses incurred before receiving the invoice/making payment. In the subsequent accounting period, where the business receives the invoice and makes the payment, it will REVERSE THE ACCRUALS and account for the expense payment
The accruals creation and the reversal of accruals are posted to the relevant ledgers using journals
Accrual Creation
The accruals creation adjustment affects two ledger accounts:
- Individual Expense (Dr, expenses increased)
- Accruals (Cr, Accruals (liability) increased)
The above double entry is for creating accruals at year-end to recognise the expense incurred that has not been paid.
The adjustment for accruals creation will have an impact on the business’s profits and net assets as follows:
- Profits – The double entry to create accruals is to debit the expenses account. Expenses increases, which will lead to a reduced profit figure.
- Net Assets – The corresponding entry is to credit the Accruals liability account.
Net assets or capital is the assets less liabilities of a business. Since liability has increased, the net assets of the business will decrease.
Reversal of Accruals and Expense Payment
In the next accounting period, the supplier will invoice the business for the expense, and the business will make payment. As a result, double entries are made for:
- the accruals reversal
- the expense payment
the reversal of accruals adjustment affects two ledger accounts:
- Accruals (Dr, Accruals (liability) decreased)
- Individual Expense, (Cr, expense decreased)
The double entry for the Expense Payment made affects two ledger accounts:
- Individual Expense (Dr, expense is recorded (increased)
- Bank, Cr, bank asset decreased
(see examples)
** a PREPAYMENT is recognised when a business pays in the current financial period for an expense that relates to the next financial period
A business recognises an expense when it receives an invoice and makes payment. However, certain expenses may be invoiced and paid before they are incurred. This is known as ADVANCE PAYMENT. The amount paid for expenses not yet incurred is recognised as a prepayment.
For example, Sunrise Lighting pays for its yearly office insurance (covering the period 1 April to 31 March) at the start of the usage period. At the end of the financial year (31st December), Sunrise Lighting paid for insurance expenses not yet incurred (January to March).
An asset is therefore recognised for the payment made in advance. The amount paid for expenses not yet incurred is known as prepayment.
Accounting Entries for Prepayments
During the year, the business makes payments for expenses not yet incurred and records EXPENSE PAYMENTS. At year-end, the business identifies which payments were made for expenses not yet incurred. Since expenses are not incurred in the year, an adjustment for PREPAYMENT CREATION is made (credit/reduces expenses).
When the business continues using the expenses in the next accounting period, it will adjust for PREPAYMENT REVERSAL.
For example, in a financial year, a supplier sends invoices to the business, and the business makes payments for the expenses. However, at year-end, it finds that the amounts paid do not relate to expenses incurred during the year. Therefore, a prepayment is recognised to reduce the expense charge for the year.
During the year, two entries occur for payments of expenses not yet incurred:
- the expense payment
- the prepayment creation
Expense Payment
The double entry for the expense payment affects 2 ledger accounts:
Dr, Individual Expense, expense increased
Cr, Bank, bank (cash) decreased
Expense Payment
The double entry for the expense payment effects two ledger accounts:
- individual expense
- bank
Dr, individual expense, expense increased
Cr, Bank, bank (cash) decreased
The above double entry reflects the supplier sending invoices to the business and where payments have been made
