Adjust expense accounts for accruals and prepayments and show them in the financial statements

What this dot point is asking

SEAB wants you to adjust an expense account for accruals (amounts owed at the year end) and prepayments (amounts paid in advance), and to show them correctly in the financial statements. The central insight is that the income statement should show the expense relating to the year, while the statement of financial position shows the amount owing as a liability or prepaid as an asset.

The answer

Accrued expenses

An accrued expense is one that has been incurred but not yet paid at the year end (for example, December's electricity, paid in January). The matching principle requires it to be charged this year:

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

Prepaid expenses

A prepaid expense is one paid in advance for next year (for example, insurance paid covering months in the next period). It is not yet incurred:

• Remove the prepaid portion from this year's expense.
• Show the prepayment as a current asset (a future benefit) in the statement of financial position.

The expense relating to the year

A reliable formula:

In words: start from cash paid, add what is still owing at the end, subtract what was owing at the start (now paid), and adjust for prepayments the same way in reverse.

Working through the expense account

The expense account is balanced so the transfer to the income statement is the balancing figure. Opening accruals sit as a credit balance b/d (owing), closing accruals as a credit balance c/d; opening prepayments as a debit balance b/d, closing prepayments as a debit balance c/d.

Examples in context

Example 1. A telephone bill spanning the year end. A firm pays \3,000$of phone charges in the year but still owes$\$250$ for December at 31 December. The income statement is charged \3,250$(the cost relating to the year), and the$\$250$ appears as a current liability. The adjustment ensures December's calls are matched to this year's income.

Example 2. Rates paid in advance. A shop pays \2,000$of council rates, of which$\$500$ covers the first quarter of next year. This year's expense is \1,500$, and the$\$500$ prepayment is a current asset. Next year, the \500$ will be charged when it relates, so each year bears only its own share of the rates.

Try this

Q1. State how an accrued expense and a prepaid expense each appear in the statement of financial position. [2 marks]

• Cue. An accrued expense is a current liability; a prepaid expense is a current asset.

Q2. Rent paid is \10,000$;$\$1\,500$ is owing at year end and there was no opening accrual. State the income statement charge. [2 marks]

• Cue. Charge = 10\,000 + 1\,500 = \11,500$, with the$\$1\,500$ accrual shown as a current liability.

Q3. Insurance paid is \3,600$, of which$\$400$ is prepaid at year end. State the expense for the year and the asset shown. [2 marks]

• Cue. Expense = 3\,600 - 400 = \3,200$; the$\$400$ prepayment is a current asset.