Study tips: Accruals concept series
The accruals concept is one of the underpinning theories of accountancy and fundamental to many daily accounting activities, yet it is the concept that as students we struggle to understand the most. When we prepare year-end accounts we have to consider the accruals concept as part of the process so it is vital we understand the theory:
Income generated must be matched with expenses incurred, within a financial period, regardless of when the money is paid or received.
What is a prepayment?
A prepayment is an expense or some income that has been paid for or received this financial year but that belongs (needs to be matched to) next year.
Theory: Income generated must be matched with expenses incurred ……
Practice: We must match up the accounts on the statement of profit or loss (SoPL), including the expenses that have been spent to generate the net sales figure.
Theory: …..in a financial period…..
Practice: Let’s say we pay an annual insurance policy that runs from 1st June to 31st May but our accounting year runs from 1st April to 31st March.
The periods don’t match. Within our financial year we need to include the last two months of the previous insurance policy and ten months of this policy.
Theory: …..regardless of when the money is paid or was received.
Practice: We are likely to pay for the insurance policy in one lump sum. So the expense incurred will have gone through the bank account in June and will cover all twelve months of the policy. Because the periods don’t match though, we can only include ten months on this year’s SoPL to match with this year’s sales, even though it’s all been paid for.
The other two months need to be pushed forward into next year’s accounts as that’s where they belong. In other words, two months of the policy have been pre-paid for next year. This has the effect of reducing this year’s expenses and increasing next year’s.
Let’s assume last year’s insurance cost £600 which would be a monthly amount of £50. If the annual premium has increased to £660 this year, the monthly cost has become £55.
To correctly match the insurance expense to our financial year we need:
2 months of last year’s policy £100
10 months of this year’s policy £550
Total insurance cost for current financial year £650
We have to learn that there are three elements to these year-end adjustments:
- Reversal of the previous year’s year-end adjustment
- Accounting for this year’s activity i.e. what money has gone through the bank account
- This year’s year-end adjustment
Once you have a prepayment or an accrual then it is likely to continue in the same pattern year after year as it becomes a cycle:
How is this reflected in the accounting records?
Let’s say our year-end is 31st March. Last year we paid £600 for our insurance. However, we needed two months of that to be included in our current year. Therefore, at the end of last year we would have reduced the insurance by £100 and double entered that into the prepayments account.
By doing that we made a provision for the prepaid amount, just whilst we moved from one year to the next.
The balance on the prepayments account is shown on the statement of financial position (SoPF) as a current asset. This is because we own those two months of insurance, as the policy was paid in full in June but they can’t be matched to this year’s income so must not be included in the SoPL.
That was the position at the end of last year. Now we need to think about this year’s accounts.
Remember the three elements:
1. Reversal of the previous year’s year-end adjustment:
It decreased the expense at the end of last year’s so it must increase the expense at the start of this year.
2. Accounting for this year’s activity ie. what money has gone through the bank:
3. This year’s year-end adjustment:
Finally, we have to decrease this year’s insurance expense because the last two months will be for next year.
All we need to do now is write off the balance on the Insurance account to the SoPL and balance the Prepayments account and show it on the SoFP.
Then the cycle will start again.
It might be worth pointing out that in this example we’ve done a lot of work for the sake of a net adjustment of £10. However, when the figures are scaled up for larger organisations and multiple transactions, then the zeros add up. If the concept of accruals was not applied the impact on reported profit figures would be significant.
In part two we’ll have a look at how the same theory of matching is applied to adjustments for accrued expenses as well as prepaid and accrued income.
Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.