To successfully achieve competence in the Accounts Preparation assessment you need to be able to apply the principles of double entry to a wide range of different types of transaction such as depreciation, inventory and irrecoverable debts. This will require a high level of familiarity with how the system of double entry works.
The syllabus area that I would like to deal with is one that students often have problems with: accruals and prepayments.
The accruals concept
One of the fundamental accounting concepts is the accruals concept. This demands that we match transactions to the period that they relate to even if the invoice is received or the cash is paid in a different period.
Accruals are used in situations where we have not recognised enough expense for the period being dealt with. This is common with utility bills as they tend to be received after the period they relate to. Let’s say that by the year-end we have received three quarterly electricity bills of £300 each (so nine months-worth of bills at £100 per month). This means that we would only currently be recognising nine months of expense (£900) in a 12 month period which is not enough.
Setting up an accrual
To set up an accrual at the end of the year we need to do two things:
- We need to increase the electricity expense to reflect the electricity used in the final three months of the year. To increase an expense we debit it.
- We need to recognise the liability that we owe to the electricity company for that last three months of electricity use. This liability is known as an accrual. To increase a liability we credit it.
This gives us the following double entry:
Debit Electricity expense £300 (taking it to £1,200 in total)
Credit Accrual £300
Reversing an accrual
Since accruals are only set up at the end of an accounting period to ensure that the expense figure recognised in the P&L account for that period is correct, they need to be removed (or ‘reversed’) at the start of the following period. The double entry used to reverse an accrual is literally the reverse of the double entry used to set it up:
Debit Accrual (to remove the liability)
Credit Expense (as part of the cash paid in the new period will actually relate to a bill related to the prior period)
Practice dealing with some accruals.
Prepayments are used in situations where we have already paid for an expense that relates to the next period. Let’s say we paid £3,000 for three years of rent (so £1,000 per annum) at the start of the first year. This payment of £3,000 would be recognised as an expense for the period but it is for three whole years which is too much to recognise in one year’s P&L.
Setting up a prepayment
To deal with a prepayment at the end of the first year we need to do two things:
- We need to reduce the amount of expense being recognised to just a single year’s worth. We do this by crediting the expense for the amount paid for the second and third years.
- We need to show an asset for the fact that we have paid for two years in advance. This asset is called a prepayment. To increase an asset you debit it.
Debit Prepayment £2,000
Credit Rent expense £2,000
Reversing a prepayment
Just like with accruals, prepayments need to be reversed at the start of the following period. Again it is the reverse of the double entry used to set them up:
Practice dealing with prepayments.
In this article we have considered applying our accruals concept to expenses. You also need to be able to deal with accrued and deferred income in a similar manner.
Gareth John is a qualified chartered accountant and tutor at First Intuition.