Account for accruals and prepayments of expenses and income, and show them in the financial statements

What this dot point is asking

SEAB wants you to adjust expenses (and income) for amounts owing or paid in advance, and to place each adjustment correctly in the statement of financial position. This is the most common adjustment in the exam. The central insight is that an accrual adds an amount owed, while a prepayment removes an amount paid early, and each one also creates a small asset or liability at the year end.

The answer

Accrued expenses

An accrued expense is a cost that has been incurred but not yet paid by the year end (for example, December wages paid in January). Because it belongs to this period:

• Add it to the expense in the income statement.
• Show the amount owing as a current liability (accruals) in the statement of financial position.

Prepaid expenses

A prepaid expense is a payment made now for a benefit in a future period (for example, insurance paid for next year). Because it does not belong to this period:

• Subtract it from the expense in the income statement.
• Show the amount prepaid as a current asset (prepayments) in the statement of financial position.

A simple rule

Income adjustments

The same idea works for income. Income owing to us (accrued income) is added to income and shown as a current asset; income received in advance is subtracted and shown as a current liability, because we still owe the service.

Examples in context

Example 1. Wages spanning the year end. A shop pays staff weekly, and at 31 December owes \700$for the final week, paid in early January. The$\$700$ is added to wages so December's profit reflects all the work done, and it sits as a current liability. Without the accrual, December would look more profitable than it really was, which is matching in action.

Example 2. An annual licence paid up front. A business pays a \1,200$annual licence in November covering twelve months. At 31 December, ten months remain unused, so$\$1,000$ is a prepayment, a current asset, and only \200$ is this year's expense. The asset shows the business has paid for a benefit it has not yet consumed, the opposite of an accrual.

Try this

Q1. State whether an accrued expense is a current asset or a current liability. [1 mark]

• Cue. A current liability, because it is an amount owed at the year end.

Q2. Wages paid were \9,000$and$\$600$ is owing at the year end. Find the wages expense. [2 marks]

• Cue. Add the accrual: 9\,000 + 600 = \9,600$.

Q3. Explain why a prepayment is subtracted from this year's expense. [2 marks]

• Cue. It is a payment for a future period's benefit, so under matching it does not belong to this year and is carried forward as a current asset.