Accruals and prepayments

This post has been produced by B J Harford FCCA, FIAB, Principal at Woodgrove Tutorials.

Woodgrove Tutorials is an IAB Accredited Training  Provider. Their  Principal, Brian J Harford FCCA is an Award Winning qualified Accountant with 36 years teaching experience in Bookkeeping & Accounts including 17 years as a Part Time Lecturer at the London Metropolitan University (formerly Guildhall University)

For website see: www.woodgrove-tutorials.co.uk.

Accountancy is based upon the accruals concept – that is expenses & sales are recognised as they are earned (in the period they relate to), rather than when cash changes hand.

As a result, we must make adjustments for invoices received near the year-end which relate to the previous or next period.

Accruals

We must accrue for expenses which are invoiced after the year-end, but relate to the current year.

For example, a telephone bill received one month after the year-end, which charges for the previous 3 months. Here, we must accrue for 2/3 of the total. This brings 2/3 of the bill into this year.

Distinguish this from a creditor, which has been invoiced before the year-end, but remains unpaid at the year-end date.

The double-entry for accruals will be dealt with in the year-end adjustments.

Prepayments

These are the opposite of accruals – where an invoice has been received before the year-end which relates in whole or in part to the next period.

For example, rates paid 6 monthly – paid 1 month before the year-end, but 5/6 of the total relates to the next period. We must set up a prepayment for 5/6 of that bill to defer it until the next period.

The double-entry for prepayments will be dealt with in the year-end adjustments.

Income

The above deals only with expenses. The same situation can occur (less commonly) with sales income.

Income received in advance (income in advance) needs to be deferred until the next period.

Income earned but not yet invoiced (accrued income) needs to be brought forward into the current period.

Please note that these can also be accounted for using an extended trial balance.

Some notes on this are:

Accruals

At the end of the financial year, expenses will have been incurred but the invoices or bills for those expenses will not have been received. These expenses are not reflected in the books of accounts because they have not been paid. So what is the firm to do? Leave them out and only include them when they have been paid?

The problem with this is that they would be included in the financial year following that in which they were incurred. It will be remembered that the heading of the Trading & Profit & Loss Account was: – Trading & Profit & Loss Account for the year ended XX.

Therefore, these outstanding expenses must be included in the year in which they were incurred even though they will not be paid until the following year.

These unpaid expenses can be brought into the final accounts by an adjustment (or extension) to the trial balance. Expenses, which are due but unpaid at the end of any financial period, are called accrued expenses.

They are catered for as follows:

Suppose a company had incurred telephone costs of £1,000 during the year and these had been paid. However, at the end of the year, an additional cost of £200 for telephone costs had been incurred but not paid. The £1,000 would show in the firm’s trial balance and the adjustment would be twofold as follows:

a)     extend the trial balance to increase the £1,000 by £200, to £1,200 and

b)    extend the trial balance to include a new account, outstanding expenses, to reflect the Creditor i.e. the person to whom the £200 is owing to.

Specifically this would appear as follows:

EXTENDED TRIAL BALANCE

TOTAL

Dr

Cr

Dr

Cr

Dr

Cr

Telephone

1,000

200

1,200

Outstanding expenses

200

200

The total column is used for the final accounts. Thus, the telephone costs charged in the profit and loss account are £1,200 – comprising the £1,000 paid together with the £200 due but not paid. The £200 (under outstanding expenses) would show as a current liability in the balance sheet.

Prepayments

This is the other side of the coin. Some expenses such as rates and insurance are paid in advance. This means that, at the end of the financial year, a portion of the expense paid will relate to next year and has therefore been paid in advance. This advance payment or prepayment relates to next year and therefore cannot be reflected in this year’s profit and loss account.

Suppose a business had paid rates of £2,000 during the year. At the end of the year £400 (of the £2,000) represented the amount relating to the following year.  Therefore, only £1,600 (£2,000 less £400) can be charged to this year’s profit & loss account. The £400 must show as a prepayment.

Adjusting the trial balance as follows attains this: –

EXTENDED TRIAL BALANCE

TOTAL

Dr

Cr

Dr

Cr

Dr

Cr

Rates

2,000

400

1,600

Prepayments

400

400

The £400 will show as a Prepayment in the current assets section of the balance sheet.

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