In part one of this two – part series on the accruals concept, we broke down the theory of matching and applied it in practice to an example of a prepaid expense.
Now we are going to extend that knowledge and understanding and use it to accrue for expenses as well as to make adjustments for income.
What is an accrual?
We said in part one that 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. An accrual is simply the opposite – an expense or some income that won’t go through the bank account until next year but that belongs in this year.
Therefore we will need to increase the balance of the appropriate account in order to correctly adjust it for an accrual as the accruals concept states that:
Income generated must be matched with expenses incurred, within a financial period, regardless of when the money is paid or received.
Let’s say at year-end, 31st March 2018, we know that an electricity bill is due for £200 and half of it belongs to this financial year. We would therefore need to increase the balance on this year’s account to accrue £100 and match the expense to the correct financial year. The double entry would also make a provision in the accruals account and will show as a current liability on the statement of financial position (SoFP), as the electricity bill is yet to be paid.
Once we can account for prepaid and accrued expenses, usually called prepayments and accruals, we can transfer our knowledge and skills to prepaid and accrued income.
The process is the same but the effect is the opposite. This is because the balance on an expense account is a debt and on an income account it is a credit so the starting point is different.
How to make adjustments for prepaid and accrued expenses and income
Firstly we have to remember the three elements that we learnt in part one:
- Reversal of the previous year’s year-end adjustment
- Accounting for this year’s activity ie. what money has gone through the bank account
- This year’s year-end adjustment
Open top of that we need to learn what effects accruals and prepayments have on account balances:
- Decrease balances at year-end. Therefore, they must increase balances at the start of the following year.
- Increase balances at year-end. Therefore, they must decrease balances at the start of the following year.
Let’s work through a scenario:
At the beginning of the year there is a balance of £900 on the accrued income account that was the result of a year-end adjustment for rent received. The cashbook shows £12,000 has been received for rent during the year. The rent receivable account needs adjusting to reflect that a payment was received for the quarter ending in April for £1,000. Remember the financial year ends on 2018.
If we break the information down into the three elements we need to start with the reversal of last year’s year-end adjustment. Often getting this posting right is the most challenging aspect of this type of year-end adjustment so asking a few questions can help ensure we start correctly.
Are we updating an expense or income account?
- Rent receivable is an income account.
Will it have a debit or credit balance?
- Income accounts have credit balances.
What was last year’s year-end adjustment for?
- It was for accrued income.
What effect did that have on last year’s balance?
- Accruals increase balances at year-end.
Therefore the reversal needs to be entered on which side of the account?
- On the debit side because accruals decrease balances at the start of the year and this is an income account which will have a credit balance.
The second element is to account for this year’s activity and the information states that, the cashbook shows £12,000 has been received for rent during the year. Therefore the double entry is:
The final element is to make the necessary adjustment at the end of this year. We know that the rent receivable account needs adjusting to reflect the fact that we received a payment for the quarter ending in April for £1,000, and that the financial year ends on 31st March.
It is especially helpful here to remember the theory we are basing all our work on; the accrual concept. We are matching income, in this case, to the correct period regardless of when the money went through the bank account. It is also useful to ask some more questions:
What time period is covered by the income?
When does this year end and next year start?
Compare when the money goes through the bank with which year it belongs in. You may have to split it between the two years in the right proportions:
This means that this year’s balance needs to be increased and therefore the adjustment is an accrual.
We can use four steps to help us with the year-end adjustments:
1. Calculate the adjustment
- £1000/3 x 2 = 667
2. Post the double entry
- SoPL account – Rent Receivable
- SoPL account – Accrued Income
3. Write off the balance on the SoPL account
4. Balance the SoFP account
Making adjustments for prepayments and accruals can be challenging as it involves applying theory, proportioning amounts and making adjustments in reverse. However, if you learn to recognise the three elements involved in the process and think through what effect an adjustment has on an account’s balance at the start and end of the year, then you are in a great position to master this tricky aspect of preparing year-end accounts.
Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.