ESTADOS DE CAMBIOS EN EL PATRIMONIO NETO
35. Contingencias y restricciones
Accruals and prepayments is a topic that book-keeping students often find difficult. It is an important topic: first, because it may be the main subject of a question; second, because it can also occur in other topics in an examination, particularly in the adjustments of final accounts. Therefore explain accrual and prepayments carefully, and make sure that the students have plenty of practice in answering questions on this topic.
Step 1
Expense accrual
1 Explain that the term ‘accrual’ refers to an amount that is owing. An expense accrual is an amount payable, in respect of an account period, that remains unpaid at the end of
Topic summary
● The meaning of expense accruals and the necessary entries or adjustments in an expense account for expense accrual
● The meaning of expense prepayment and the necessary entries or adjustments in an expense account for expense prepayment
● Adjustments for expense accruals and prepayments in final accounts
Extended Syllabus references 13.1 The nature of an accrual
13.2 End-of-period adjustments in expense accounts for accruals 13.3 The meaning of an expense prepayment
13.4 End-of-period adjustments in expense accounts for prepayments
13.5 Adjustments for end-of-period expense accruals and expense prepayments in the Profit & Loss Account and balance sheet
20.7 The appropriate inclusion of prepayments and accruals under ‘current assets’ and
‘amounts payable within 12 months’ respectively
Aim: to understand expense accruals and to be able to make the necessary entries or adjustments in an expense account
that period.The students’ aim is to relate the expenses to the periods (usually years) in which the benefit is obtained from the expenditure, whether or not the expense accounts have been paid.This may require making adjustments in the expense accounts.
2 Illustrate accrual by showing the example below on the overhead projector or board.
Example
Jacqui Tillot commenced in business at 1 January Year 3. She pays £500 rent ‘in arrears’
at the end of each quarter. At 31 December Year 3, the fourth quarter’s rent is still unpaid. Her Rent Account appears as follows:
Rent
Year 3 £
31 Mar Bank 500
30 Jun Bank 500
30 Sep Bank 500
3 Ask the students what is wrong with this example.
4 The problem with the example is that this Rent Account records the rent for only 3 quarters; the rent for the fourth quarter will probably be paid early in Year 4. Left as it is, the account gives a misleading picture for Year 3 because Jacqui has benefited from the use of the premises for 4 quarters in that year. The true charge for the rent for Year 3 is:
4 quarters at £500 per quarter = £2,000
Jacqui Tillot’s Profit & Loss Account for Year 3 should show £2,000. The £500 in respect of the fourth quarter should be treated as a liability. The account would then appear as:
Rent
Year 3 £ Year 3 £
31 Mar Bank 500 31 Dec Profit & loss 2,000
30 Jun Bank 500
30 Sep Bank 500
31 Dec Balance c/d 500
2,000 2,000
Year 4
1 Jan Balance b/d 500
5 Show the correct Rent Account (above) on the overhead projector or board.
6 Explain that the £2,000 credit entry is matched by a debit of that amount to the Profit
& Loss Account. The ‘correct’ charge for the year is thus made in the Profit & Loss Account. The £500 balance carried down at 31 December Year 3 is matched by the credit brought down at 1 January Year 4. This credit balance represents a liability and appears as such in the balance sheet at 31 December Year 3.
Accruals and prepayments – expenses
7 Show the students that early in Year 4, Jacqui Tillot’s Rent Account might appear as follows:
Rent
Year 4 £ Year 4 £
18 Jan Bank 500 1 Jan Balance b/d 500
This illustrates that the overdue rent is paid on 18 January, which clears the account.
8 It is essential that the students grasp the meaning of these account entries. Review the key entries, which show that:
● the transfer to the Profit & Loss Account is the due amount of rent for Year 3 – not what has actually been paid. The transfer ensures that the ‘true’ charge is made in the Profit & Loss Account;
● the credit balance (brought down) at 1 January Year 4 represents the amount owing at that date, which would appear as a liability in the balance sheet at 31 December Year 3;
● the debt is cleared early in Year 4.
9 Ask the students to work through the following exercise.
Exercise
Douglas Miller commenced in business at 1 October Year 5. He paid monthly staff salaries in arrears by cheque as follows:
Year 5 £
31 Oct 1,200
30 Nov 1,200
At 31 December Year 5, salaries for December amounting to £1,400 were unpaid.
Required
Prepare the Salaries Account for the 3 months ending 31 December Year 5, duly balanced at that date.
Solution
Salaries
Year 5 £ Year 5 £
31 Oct Bank 1,200 31 Dec Profit & loss 3,800
30 Nov Bank 1,200
31 Dec Balance c/d 1,400
3,800 3,800
Year 6
1 Jan Balance b/d 1,400 Accruals and prepayments – expenses
Step 2
Expense prepayment
1 Explain that the term ‘expense prepayment’ is a payment made in advance of the account period to which it refers.A prepayment is the opposite of an accrual. However, the transfer to the Profit & Loss Account in the expense account will still be credited.
The difference is in the balance, which is brought down as a debit balance, ie as an asset.
2 Illustrate prepayment on the overhead projector or board with the following example.
Example
James Jewell commenced in business at 1 January Year 7. He paid his rent quarterly and in advance by cheque as follows:
Year 7 £
Show the Rent Account for Year 7, duly balanced at 31 December Year 7.
Solution
Rent
Year 7 £ Year 7 £
2 Jan Bank 450 31 Dec Profit & loss 1,850
28 Mar Bank 450 31 Dec Balance c/d 475
26 Jun Bank 475
1 Oct Bank 475
28 Dec Bank 475
2,325 2,325
Year 8
1 Jan Balance b/d 475
3 Review the example’s solution by drawing attention to the following points:
● the transfer to the Profit & Loss Account includes 2 quarters’ rent at £450 (£900) plus 2 quarters’ rent at £475 (£950), which results in a total transfer of £1,850;
● the balance (£475) brought down at 1 January Year 8 will appear as an asset in the balance sheet of James Jewell at 31 December Year 7.
Accruals and prepayments – expenses
Aim: to understand expense prepayment and to be able to make the necessary entries in an expense account
4 Explain that, so far, the examples given have had no opening balance since they illustrate the first year of trading. It is more usual to have an opening balance as well as a closing balance.
5 Emphasize the rule about prepayment and accrual:
if a prepayment, the opening balance = Debit if an accrual, the opening balance = Credit
Example
From the following details, prepare John Sim’s Insurance Account for the year ended 31 December Year 6. Balance the account at the year end, showing the transfer to the Profit & Loss Account.
Year 6
1 Jan The balance on the account is £80, representing one quarter’s insurance paid in advance
23 Mar The amount of £190 is paid by cheque, which covers the insurance for the half-year ended 30 September Year 6
29 Sep The amount of £210 is paid by cheque, which covers the insurance for the half-year ended 31 March Year 7
Solution
Insurance
Year 6 £ Year 6 £
1 Jan Balance b/d 80 31 Dec Profit & loss 375
23 Mar Bank 190 31 Dec Balance c/d 105
29 Sep Bank 210
480 480
Year 7
1 Jan Balance b/d 105
Note
The transfer to the Profit & Loss Account is made up of:
£
Jan–Mar 80
Apr–Sep 190
Oct–Dec 105
375
Explain that the remaining £105 has been paid in advance for the quarter ended 31 March Year 7 and is carried down as an asset (debit) balance.
Accruals and prepayments – expenses
Accruals and prepayments – expenses
6 Point out that expense accounts involving accrual, prepayment, or both (and including an opening balance) are made up of 4 elements:
(i) the amount either accrued or prepaid at the beginning of the year;
(ii) the amount paid during the year;
(iii) the amount to be transferred to the Profit & Loss Account, ie the ‘true’ cost for the year;
(iv) the amount owing or prepaid at the end of the year.
These elements may be shown as a single example (see Figure 13.1).The example may be described as a situation of initial accrual and closing prepayment. If 3 of the elements are known, the fourth can be found by preparing an expense account based on the relevant structure.The diagrams can be adapted to each situation. Each situation will be determined by, first, the particular combination of opening and closing balances, such as initial prepayment and closing accrual (see point 8 below); and, second, the respective amounts of the 4 elements as outlined in point 6 above.
Figure 13.1 A pictorial example of an expense account
7 Display the example on the overhead projector. The basic structure can be copied on to a transparency and used as the master diagram, and sample figures can be copied on to a number of other transparencies. Insert the figures progressively by placing the transparencies on top of one another.
8 Ask the students to construct simple diagrams (like the one above) that show the following situations, which should all relate to expense:
(a) initial accrual and closing accrual
(b) initial prepayment and closing prepayment (c) initial prepayment and closing accrual (d) initial accrual and closing prepayment.
The students may find it helpful to practise constructing simple diagrams (in double-entry account form) that position the various items.
Amount paid
Another form of prepayment
9 Explain that a prepayment could take the form of items purchased for use in the business, which are separate from ordinary ‘purchases’ that are for resale. Purchases for use in the business might include stationery, packing materials, or cleaning materials.
Any stock of such items at the end of an accounting period represents a form of prepayment.
Draw the students’ attention to the following points:
● allowance must be made for stock at the end of an accounting period in the figure charged to the Profit & Loss Account;
● the value placed on the stock must be carried down as a balance on the expense account.
10 Illustrate the two points above with the following example.
Example
Stationery bought in the year ended 31 December Year 3 cost £2,750. The stock of stationery held at 31 December Year 3 is worth £250
Required
Prepare the Stationery Account for the year ended 31 December Year 3.
Solution
The amount used is £2,750 - £250 = £2,500. This total is charged to the Profit &
Loss Account and the amount remaining (stock) is carried forward as an asset balance.
Stationery
Year 3 £ Year 3 £
Jan–Dec Sundries 2,750 31 Dec Profit and loss 2,500 31 Dec Balance c/d 250
2,750 2,750
Year 4
1 Jan Balance b/d 250
Stress that any such balance should not be included with the stock-in-trade, but should be shown separately as part of the item ‘prepaid expenses’.
11 Copy and hand out or display the following exercise on the overhead projector. Ask the students to work through it.
Exercise
Cleaning materials bought in the year ended 31 December Year 4 cost £870.The stock of cleaning materials at 31 December Year 4 is worth £130. The cleaning materials bought in the year ended 31 December Year 5 cost £920. The stock of cleaning materials at 31 December Year 5 is worth £150.
Accruals and prepayments – expenses
Required
Show the Cleaning Materials Account for the 2 years ended 31 December Year 5.
Note
The stock at 31 December Year 4 (the closing stock) is also the stock at 1 January Year 5 (the opening stock).
Solution
Cleaning Materials
Year 4 £ Year 4 £
Jan–Dec Sundries 870 31 Dec Profit & loss 740
31 Dec Balance c/d 130
870 870
Year 5 Year 5
1 Jan Balance b/d 130 31 Dec Profit & loss 900
Jan–Dec Sundries 920 31 Dec Balance c/d 150
1,050 1,050
Year 6
1 Jan Balance b/d 150
Note
The charge to the Profit & Loss Account is calculated as:
Year 4 Purchased stock at £870 less closing stock at £130 = £740 Year 5 Opening stock at £130 plus purchased stock at £920 = £1,050
less closing stock at £150 = £900
12 Explain that the financial period or year of the firm does not always correspond with that of the supplier of services. Adjustments to deal with this mismatch may be necessary at the end of the accounting period.
Example
At 1 January Year 5, the Insurance Account has a balance of £90 (Dr). The insurance premium was paid by cheque £330 on 28 April Year 5 for the (insurance) year to 30 April Year 6.
Required
Show the Insurance Account for the year ended 31 December Year 5, duly balanced at that date.
Note
It can be concluded that the debit balance at 1 January Year 5 relates to Insurance for the 4 months ended 30 April Year 5. The charge for the remaining 8 months of the financial year is calculated as the due proportion of the annual premium: £330 ×8/12
= £220. The remaining £110 is carried forward as a prepayment. The charge to the Profit & Loss Account for insurance for Year 5 is: £90 + £220 = £310.
Accruals and prepayments – expenses
Insurance
Year 5 £ Year 5 £
1 Jan Balance b/f 90 31 Dec Profit & loss 310
28 Apr Bank 330 31 Dec Balance c/d 110
420 420
Year 6
1 Jan Balance b/d 110
13 Copy and hand out or display exercise T/13.1* in the Appendix (page 241) on the overhead projector.Work through it with the class. Exercise T/13.1 concerns 3 expense accounts: 2 accounts (rent and insurance) have opening prepayment balances, ie debits;
the other (advertising) has an opening accrual balance, ie credit. You should first calculate the amount of the charge for Year 4 for each expense. In examination answers, if workings are shown clearly, marks can be awarded for what is correct.
It is clear that the monthly rent is £230 from January to September and £250 from October to December.
Period of rent (Year 4) Prepayment balance 1 Jan Yr 4 = Jan
Payment 28 Feb = Feb, Mar
31 May = Apr, May, Jun
31 Aug = Jul, Aug, Sep
30 Sep = Oct
Thus the accrual of 2 months’ rent at 31 December Year 4 is 2 ×£250 = £500.
With regard to insurance:
● the initial prepayment of £65 covers the period 1 January to 31 August;
● the charge for the period 1 September to 31 December Year 4 is the due part of the premium paid on 31 August Year 4, ie £180 × 4/12 = £60;
● the other £120 is carried forward as a prepayment for Year 5.
Therefore the total insurance charge for Year 4 is £65 + £60 = £125.
The following are major weaknesses shown by candidates in answers to exercise T/13.1 (an LCCIEB past examination question):
● failure to calculate correctly the charge to the Profit & Loss Account in the Rent Account;
● charging an incorrect proportion to the Profit & Loss Account from the insurance premium paid on 31 August Year 4;
● being confused about applying double-entry rules, which is sometimes done inconsistently.
Draw the students’ attention to these weaknesses as appropriate.
Accruals and prepayments – expenses
Step 3
1 Remind the students that, at the financial year end, some expenses will be paid in advance of the forthcoming year, while other expenses will be in arrears, ie ‘accrued’.
This often occurs because the firm’s financial year and the payment year for the expense do not correspond. Adjustments may therefore be necessary when preparing final accounts.
2 This topic can be developed with reference to the final accounts of T Avis in Lesson 7 (page 40).
3 The following adjustments are to be made in relation to the balances included in the trial balance of T Avis at 31 December Year 6:
● rent payable prepaid – £100
● lighting and heating accrued – £60.
4 Trading and Profit & Loss Account
The effect of the adjustments is limited to the Profit & Loss Account, so only that need be shown on the overhead projector.
T Avis
Profit & Loss Account
for the year ended 31 December Year 6
£ £
Rent payable (1,100-100) 1,000 Gross profit 3,570
Office expenses 590 Rent receivable 450
Lighting and heating (610 + 60) 670
Carriage outwards 380
Net profit 1,380
4,020 4,020
The effect has been to increase the net profit of the adjustments:
£ Net profit before adjustment 1,340
add Rent payable prepaid 100
1,440 less Lighting and heating accrued 60
Net profit after adjustment 1,380
Accruals and prepayments – expenses
Aim: to be able to make necessary adjustments for accruals and prepayments in final accounts
5 Balance sheet
To illustrate the remaining effects of the adjustments mentioned in point 3 (page 97), show the following balance sheet on the board or overhead projector:
T Avis
Balance sheet at 31 December Year 6
Fixed Assets £ £ £ less Amounts due within 1 year
Creditors 1,750
Accrual 60 1,810
3,210 5,710 Financed by:
Capital – balance at 1 Jan Yr 6 5,430
add Net profit 1,380
less Drawings 1,100 280
5,710
Note
Period-end prepayments should be shown under current assets, and positioned after
‘debtors’ but before ‘bank’. If there is more than one prepayment, these do not have to be listed individually. It is advisable, however, to record the separate amounts (in brackets) beside the total figures.Then candidates can be sure of obtaining marks for the parts that are correct.
6 Point out that period-end accruals should be shown under ‘amounts due within 1 year’.
If there is more than one accrual, the individual amounts should be shown.
7 Copy and hand out or display exercises T/13.2, T/13.3, T/13.4 in the Appendix (pages 243–5). Ask the students to work through them.
Accruals and prepayments – expenses