Accruals and prepayments of expenses and income

Last time

Before we start: last time, in Sales and purchases ledger control accounts, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Matching to the right year

A business's year ends on 31 December, but it pays its electricity bill in January for December's use. That December electricity still belongs in this year's profit. Accruals and prepayments make sure every expense and income is matched to the year it belongs to.

The accruals concept

The accruals, or matching, concept says income and expenses are recorded in the year they are earned or used, not when cash moves. So the expense in the income statement is what belongs to the year, not what was paid. Any difference becomes an accrual or a prepayment in the statement of financial position.

Accrued expenses

An accrued expense is an expense used in the year but not yet paid by the year end. Annual rent is 6,000 dollars, but only 5,500 has been paid. 500 is accrued. The income statement shows 6,000; the 500 is a current liability.

Prepaid expenses

A prepaid expense is an amount paid this year for something that belongs to next year. Insurance of 1,300 dollars was paid, including 300 for next year. Only 1,000 belongs to this year. The income statement shows 1,000; the 300 is a current asset.

Expenses at a glance

For expenses: an accrual adds to the charge and is a liability; a prepayment reduces the charge and is an asset.

Income: the mirror image

Accrued income is income earned but not yet received, such as rent owed by a tenant. It is added to income and is a current asset. Prepaid income is received in advance for next year. It is subtracted from income and is a current liability. So for income, the signs are the reverse of expenses.

Worked: rent receivable

A business lets part of its building for 400 dollars a month: 4,800 dollars for the year. It has received only 4,400. So 400 is accrued income, owed by the tenant. The income statement shows 4,800 rent received; the 400 is a current asset.

The ledger account

In the expense account, the accrual is a balance carried down on the debit side, then brought down on the credit side, a liability. A prepayment is carried down on the credit side and brought down on the debit side, an asset. The transfer to the income statement is the amount belonging to the year.

Opening balances

Last year's accrual is paid this year, but belongs to last year, so it reduces this year's expense. Last year's prepayment belongs to this year, so it adds to this year's expense. So the expense = paid, minus opening accrual, plus closing accrual, plus opening prepayment, minus closing prepayment.

Mistakes that lose marks

Mistake one: putting an accrued expense as a current asset. It is a liability. Mistake two: charging the amount paid, not the amount for the year. Mistake three: treating prepaid income as an asset. The fix: owed by us is a liability; owed to us, or paid ahead by us, is an asset.

The full-marks tip

The full-marks tip: ask: does the business owe it, a liability, or is it owed to the business, an asset? The income statement always shows the amount belonging to the year.

On one card

So, on one card: accruals and prepayments. Keep it for revision.