An accrual adjustment is required when goods or services have been provided to a customer or have been received from a supplier before the end of the financial period but are only recorded in the business’ day books or cash book after the end of the financial period. Accruals therefore bring income or expenses forward into an earlier financial period.
There are two types of accrual, accrued expenses and accrued income. To record an accrued expense we would increase/debit the expense in the Statement of Profit or Loss and increase/credit the current liabilities of the Statement of Financial Position.
To record accrued income we would increase/credit income in the Statement of Profit or loss and increase/debit the current assets of the Statement of Financial Position.
[Note that accruals recorded at the end of a financial period will be reversed at the start of the next financial period.]
A prepayment adjustment is required when goods or services have been invoiced for or paid for before the end of the financial period but are provided after the period-end. Prepayments therefore move income or expenses from a current financial period into a later financial period.
To record a prepaid expense at a period end we would decrease/credit the expense in the Statement of Profit or Loss and increase/debt the current assets in the Statement of Financial Position.
To record prepaid income at a period end we would decrease/debit income in the Statement of Profit or Loss and increase/credit the current liabilities in the Statement of Financial Position.
[NB. As was the case with accruals, when prepayments are recorded at the end of a financial period, they will then be reversed at the start of the next financial period.]
Identify whether the following situations require an accrued expense, accrued income, prepaid expense or prepaid income to be recorded
a) Before its year-end, a company pays a supplier for goods that are received after the year-end
b) A company has provided services to a customer before its year-end but the company issues its invoice for the services after the year-end
c) A company has received services from a supplier before the year-end but receives the suppliers invoice for the services after the year-end
d) A company has invoiced a customer before the year-end for goods that will be delivered after the year-end
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a) Prepaid expense
b) Accrued income
c) Accrued expense
d) Prepaid income
Kicks Ltd has prepared its financial statements for the year ended 30/06/2019, extracts of which are shown below.
Kicks Ltd has yet to adjust its financial statements for the following two items:
- After the year-end, the company received an invoice from a supplier for £5,000 in respect of materials delivered to Kicks Ltd before the year-end (note that these materials have been included in the value of the closing inventories)
- Before the year-end, the company paid £8,000 for insurance, of which £7,000 relates to the period after the year-end. Kicks Ltd treats insurance as an administrative cost
Invoice from a supplier – £5,000
The invoice from the supplier will be recorded in the company’s books after the year-end but the expense should be recorded in the financial statements for the year ended 30/06/2019.
We would therefore record an accrued expense at the year-end as follows:
Dr Cost of Sales £5,000
Cr Trade and other payables £5,000
The postings would have the following effects. It would increase the company’s Cost of Sales in the Statement of Profit or Loss for the year ended 30/06/2019 by £5,000 and also increase its Trade and Other Payables in the Statement of Financial Position by the same amount. Finally, the accrual will affect the company’s profit for the year and will therefore affect the company’s Retained Earnings.
The insurance payment of £8,000 will be recorded as an expense in the company’s books for the year-ended 30/06/2019 but £7,000 relates to the next financial year. Administrative expenses in the Statement of Profit or Loss for the year ended 30/06/2019 therefore need to be reduced by £7,000 and Trade and Other Receivables in the Statement of Financial Position would be increased by the same amount. The postings would be as follows:
Cr Administration expenses £7,000
Dr Trade and other receivables £7,000
The Statement of Profit or Loss and the extracts from the Statement of Financial Position will thus be altered as follows:
Note that the Retained Earnings in Kick Ltd’s Equity will also be amended due to the change in the company’s profit.
After its year-end of 30/11/2020, a company receives an electricity bill for £7,200 from its supplier. The bill covers the three months to 31/12/2020.
Record a journal for the year ended 30/11/2020 to record the year-end adjustment for this invoice.
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Two thirds of the overall bill of £7,200 relates to the year ended 30/11/2020; i.e. £4,800 and an accrued expense for this amount should be recorded
Debit Electricity £4,800
Credit Accruals £4,800
Before its year-end of 30/06/2020, a company issued an invoice to a customer for £1,550. The invoice was to provide maintenance services from 01/04/2020 to 30/09/2020.
Record a journal for the year ended 30/06/2020 to record the year-end adjustment for this invoice.
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Three sixths of the invoice relates to services to be provided after the year-end. A prepaid income adjustment needs to be made for this
Debit Sales revenue £775
Credit Prepayments £775
Effects of accruals and prepayments on the Statement of Changes in Equity and the Statement of Cash Flows
As accruals and prepayments affect a company’s profit or loss for the period, they will affect a company’s Retained Earnings as recorded in the Statement of Changes in Equity.
Accruals and prepayments will also affect the way that the company will calculate Net Cash Flows from Operating Activities in the Statement of Cash Flows (see section 4).