Accruals and Prepayments

13.1 Accruals Concept

Suppose the business has used electricity in the recent three months but has not received the invoice from the electricity company as at the Financial Statements year end. Should the business recognise electricity expenses or not? The answer is yes because the business needs to match the income earned with expenses, to calculate profits or losses. Without electricity, the business may not have produced and sold those high-quality products. Hence, even if the business has not paid for electricity expenses, the business still needs to account for those expenses to reflect that the electricity has been used. This is known as ‘accruals’ or ‘matching’ concept. Other examples of accruals include:

13.1.1 Example one: invoice is due

The business has not paid the invoice from the supplier for the use of electricity as at the year end, although the invoice is due. If we have received the invoice from the electricity supplier but we have not paid it yet, we do need to provide for an electricity expense and liability to reflect the fact we owe money to the supplier.

13.1.2 Example two: depreciation

Depreciation expense for the non-current assets which must be provided for. This is because when the non-current asset is used in the daily business operations—such as machinery—these machineries are likely to become less and less efficient as time passes. From the accounting’s point of view, we do need to write down the machinery’s value, but the value written down will be very subjective, i.e., according to our judgement. The depreciation expense will never be settled in cash, and this is just an accounting adjustment, i.e., to artificially match the income the business generates from using the machinery to the expense we think it may have incurred.

13.1.3 Example three: unsold inventories

Unsold inventories need to reduce the costs of sales. Costs of unsold inventories should not be recognised as the cost of sales because we only match the costs of those sold inventories with their associated income.

13.1.4 Example four: income tax estimate

The estimate of income tax expense for the current period should be provided for. This is to match the income the business generates in the current period, with the estimated tax expense to calculate the net profit.

13.2 Accrued Expense vs. Accrued Income

For instance, the landlord rents office space to company A. As at 31st December (year end), the landlord has not invoiced company A because the next billing date is on 30th January. Hence, the landlord should recognise an accruals adjustment and company A (the tenant) should also recognise an accruals adjustment. In this case, to the landlord, this is an ‘accrued income’ which is the income earned by the landlord but not yet invoiced. To company A or the tenant, this is an ‘accrued expense,’ an expense which should be recognised but is not yet invoiced.

13.3 Accrued Expense Accounting Treatment

From the above example, the accrued expense is recognised from the user or buyer’s perspective. This is an expense incurred by the user, but it has not been paid as at the reporting date or year end. However, this will be paid after the reporting date. The term ‘accrued’ means to increase or accumulate the estimated expense. Hence, according to the accruals concept, the following journal entry needs to be made:

Step 1: The year-end estimated expense:

Dr Expense (administrative/cost of sales/distribution costs)

Cr Accrued expense

The debit side of the above journal entry is recorded in the statement of profit or loss to reduce the current year’s profit. The credit side of the above journal entry is recorded in the statement of financial position as a current liability.

Just a quick note here; the accrued expense can be for anything not yet invoiced, or which must be paid for but has not yet been paid. Unpaid wages, overtime payment, commission, interest, holiday pay, bonus due, payroll taxes, property taxes and goods received but not yet invoiced or paid need to be accrued. Some businesses may use the Goods Received Note to estimate the total accrued expense liability. For instance, suppose the buyer has bought goods from the seller on a frequent basis and, as at the year end, the buyer knows it has received 300 kgs of stocks (by checking its Goods Received Note) and according to the normal transaction price, should have paid $50,000. However, the buyer has only settled $40,000 during the year, since it acknowledges there might be additional rebates offered by the seller for the goods acquired. As at the year end, the buyer has not received the invoice for the remaining payment from the seller; in this case, the buyer decides to recognise the accrued expense liability of $10,000.

Step 2: When the expense is paid for after the year-end:

After the year end, the buyer receives the invoice from the supplier, and the invoice is therefore settled. The buyer should first remove the above journal and then recognise the new expense and a reduction in cash:

Dr Accrued expense		Dr Expense
Cr Expense		Cr Bank

Example:

S&T has set up the business on 1st February and its year end is 31st December. The business receives and settles its utility bill quarterly in arrears. During the current year, the following bills are received and paid:

31st July – 31st October (for three months): S&T pays $600

1st November – 31st December (for two months): S&T has not yet received the bill

Next year, on 30th January, S&T will receive and pay the bill for $650.

Let’s apply the above two-step approach to account for the accruals transaction.

Step 1: The year-end estimate:

Dr Expense $400

Cr Accrued expense $400

The $400 is calculated by dividing the latest utility bill of $600 into three months which gives us an expense of $200 on average each month. We then multiply the monthly $200 expense by two months before the year end, and therefore, the estimated expense is $400.

Step 2: When the expense is paid for after the year end:

Reverse the above journal:

Dr Accrued expense $400

Cr Expense $400

To debit the accrued expense is to reduce the liability by $400. To credit an expense is to reduce it by $400. Because S&T now receives the actual bill of $650, the following journal entry needs to be made:

Dr Expense $650

Cr Bank $650

The reason we do not adjust the $400 in last year’s accounts is that when S&T prepares these, the best year-end estimate it can make is based on the latest utility bill (received from the supplier) of $600. Hence this is a ‘change in accounting estimate’ which should be accounted for prospectively.

The effect on the statement of financial position is thus:

Accrued expense liability: reduce by $400
Bank asset: decrease by $650
Net decrease in equity: $250

The effect on the statement of profit or loss:

Expense: reduce by $400
New expense to be recognised when the invoice is received: increase by $650
Net decrease in income and profits: $250

13.4 What Might Go Wrong Regarding the Accrued Expense

In actual practice, because the accrued expense is merely an estimated figure not usually significant or material to the Financial Statements, some accountants may falsify this figure to make the Financial Statements look better. For example, they may understate the expense to make the profits look better, i.e., to better help the management achieve the profit target. Below are some common examples:

The post year-end bonus payment expense may be falsified, but this could be detected by the bank statement or cash book.
The outstanding tax payments due according to correspondence with the tax authority may not be shown.
Some trade payable accruals may not be recorded as at the year end, but could be detected by obtaining the supplier statement and checking if any outstanding payments need to be made.
Payroll costs including overtime payments and bonuses may be underestimated and significantly lower than the previous year’s figures. Payroll records including sales targets and bonuses due to employees may be falsified. For senior employees such as directors, board minutes can be reviewed to ensure that the amount is not under or overstated. Conversely, the accrued expense for employees may seem relatively high in comparison to others, therefore requiring more in-depth attention.

13.5 Accrued Income Accounting Treatment

Based on the above example, the utility company provides a utility service to S&T. From the utility provider’s perspective, an accrued income should be recognised. Hence the two-step approach again should be followed:

Step 1: The year-end estimate:

Dr Accrued income (similar to accounts receivable)

Cr Income

Step 2: When the funds are received after the year end:

After the year end, the service provider issues the invoice, and the buyer/user settles the bill. Hence, the service provider should remove the above accrued income asset and the income, followed by increasing the cash asset and the new income.

Dr Income		Dr Bank
Cr Accrued income		Cr Income

Step 1: The year-end estimate:

The reason for this is because the service provider will only issue the bill after the year end. Therefore, an estimate needs to be provided.

Step 2: When the money is received after the year end:

Dr Income $400

Cr Accrued income $400

This is to remove the above income and the accrued income asset, because now, the service provider has issued the invoice of $650 for the three months’ bills to S&T. When the service provider receives money from S&T, the following journal entry should be made:

Dr Bank $650

Cr Income $650

The effect on the statement of financial position:

Accrued income asset: reduce by $400
Bank asset: increase by $650
Net increase in asset: $250

The effect on the statement of profit or loss:

Income: reduce by $400
Income for the money received: increase by $650
Net increase in income and profits: $250

13.6 Prepaid Expense Accounting Treatment

For instance, when the business pays the insurance fees, these should be prepaid.

Example:

Suppose the business has signed its insurance contract on 1st June, where its Financial Statement year end is 31st December. The business has paid $1,200 insurance costs, covering the period from the 1st June this year to 1st June next year. This means the business has prepaid the next year’s five months’ insurance costs when it comes to 31st December.

But we should only recognise the expense for the current year, and we should not bring the next year’s expense into the current year’s account. In this case, only seven months’ costs should be recognised in the current year’s statement of profit or loss. The next year’s five months’ prepaid insurance costs should be removed from the current year’s expense. Let’s apply the two-step approach.

Step 1: The year-end adjustment:

Dr Prepaid expense (current asset)

Cr Expense (reduce the expense in the statement of profit or loss)

Step 2: Reverse the journal entry and recognise the new expense:

Dr Expense		Dr New expense
Cr Prepaid expense		Cr Cash

Let’s now apply the two-step approach to the above example.

On 1st June, the business has paid $1,200 of insurance costs. Hence, the following journal entry applies:

Dr Insurance costs $1,200

Cr Bank $1,200

As at the year end of 31st December:

Step 1: The year-end adjustment:

Dr Prepaid expense ($1,200/12 months x 5 months) $500

Cr Expense (next year’s 5 months’ prepayment) $500

Step 2: Reverse the journal entry and recognise the new expense:

In January, i.e., one month past the year end, the business has still prepaid the next four months, but now, the one-month prepaid expense can be reversed as follows:

Dr Expense ($1,200/12 months x 1 months) $100

Cr Prepaid expense $100

In February, March, April and May, the same entry applies:

Dr Expense $100 x 4 = $400

Cr Prepaid expense $100 x 4 = $400

Hence, at the end of May, all prepaid expenses have been reversed to zero, i.e., the prepaid expense or prepayment has now gone into the statement of profit or loss as expenses.

13.7 Prepaid Income Accounting Treatment

The same as we’ve seen in the above accrued income adjustment, the prepaid expense adjustment is from the buyer’s perspective, while the prepaid income adjustment is from the seller’s perspective.

From the above example, the insurance company has received $1,200 insurance fee from the business. The insurance company should make the following journal entry when the $1,200 fee is received in July:

Dr Bank $1,200

Cr Income $1,200

As at the year end, the two-step approach applies.

Step 1: The year-end adjustment:

Dr Income ($1,200/12 months x 5 months) $500

Cr Prepaid income (Liability in the statement of financial position) $500

To debit the income of $500 is to reduce it, because the $500 income is the next year’s. The next year’s income received in advance should also be recognised as a liability. It is like a $500 money deposit by the customer to the insurance company.

Step 2: Reverse the journal entry and recognise the new income:

In January, i.e., one month past the year end, the prepaid income can be reversed as follows:

Dr Prepaid income ($1,200/12 months x 1 months) $100

Cr Income $100

The prepaid income liability is reduced by $100 and the income has increased by $100. This reflects the fact that the insurance company has fulfilled the contract for an extra month already. Hence this one-month income can be recognised by the insurance company.

In February, March, April and May, the same entry applies:

Dr Prepaid income $100 x 4 = $400

Cr Income $100 x 4 = $400

Hence at the end of May, all the prepaid income liabilities have been reversed to nil, i.e., the prepaid income liability has now become income.

13.8 Other Examples of Prepaid Expense or Prepaid Income:

Prepaid insurance costs
Prepaid office supplies
Prepaid maintenance agreements
Prepaid rents for office space or use of equipment

Please note that the prepaid rent income is different from the accrued rent income, and the accrued rent expense is different from the prepaid office rent expense. The difference between the ‘accrued expense’ and the ‘prepaid expense’ is that the ‘accrued expense’ means the user has used the office and not yet paid; however, for ‘prepaid expense’, this means the user has prepaid all the money for the use of the office. When it comes to the opposite side, i.e., the ‘accrued income’ and the ‘prepaid income’, the ‘accrued income’ means the landlord has not yet received the money from the tenant. But for ‘prepaid income’, the landlord has received the income from the tenant in advance, prior to the tenant using the office.

13.9 Quick Summary of This Chapter

Accrued expenses: to increase the expense and liability.
Prepaid expense: to increase the prepaid expense asset and reduce the expense.
Accrued income: to increase the accrued income asset and income.
Prepaid income: to reduce the income and increase the prepaid income liability.

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Categories: : Financial Accounting (FA)