Accounting for accruals and prepayments

Accounting for accruals and prepayments

Frederick, David

Credit managers and students of credit management have at some time in their careers come across accruals and prepayments. If you haven’t as yet, you soon will. While this imay be true, from experience practitioners rarely use such grand accounting terms. It is perhaps more common to refer to accruals and prepayments in terms of movies owed by the firm and movies owed to the firm at the end of an accounting period.

However, the credit management staff are responsible for managing and controlling both the movies owed to the firm and those that the firm owes to third parties. If allowed to go unchecked, movies owed to the firm can spiral out of control and may develop into bad debts. Moreover, uncollected movies put the firm’s cash resources under pressure especially when operating under low or tight margins.

Similarly, the late payment of bills could result in additional charges being levied on the firm. Furthermore, the firm may earn the unwanted reputation within its sector for being a slow or late payer. Such a label will affect its ability to obtain credit from new suppliers.

In addition to being responsible for the accruals and prepayments, credit management students must be familiar with the accounting for accruals and prepayments. The topic is a specific learning outcome in the Accounting syllabus.

Definition

An accrual is an item of expenditure that has been incurred in the accounting period, but has not been paid for at the end of this period. For example, an invoice for goods which have been received but remains unpaid at the end of the accounting period.

A prepayment is an item of expenditure that has been paid for in the accounting period, but the consumption of the goods or services will occur in a future accounting period. For example, a firm has paid its business rates to 31 March 2001, but its accounting year ends on 31 December 2000. The payment for the period 1 January 2001 to 31 March 2001 is a prepayment, because it relates to business rates for the next accounting year.

Accruals and prepayments occur because of the matching principle. Accounting profit is derived by matching the income receivable for a period against the expenditure payable in the period. Therefore, any expenditure payable but not yet paid is an accrual. Conversely any payment made which was not due and payable in the accounting period is a prepayment.

Accounting treatment of accruals aid prepayment

At the end of the accounting period any accruals and prepayment have to be reflected in a firm’s profit & loss account and its balance sheet. In the case of an accrual the following accounting adjustment to the trial balance is required:

Debit: Item of expenditure Credit: Creditor account

This has the effect of adding the unpaid item of expenditure to the appropriate expenditure classification in the profit & loss account. Thereby, not overstating the accounting profit for the period. The respective creditor account will form part of the trade creditors’ or the sundry creditors’ balance in the balance sheet at the end of the accounting period.

Prepayments are accounted for in the trial balance as follow Debit: Debtors account Credit: Item of expenditure

This ensures that the prepaid amount is deducted from the appropriate expenditure classification in the profit & loss account. The accounting profit for the period will not be understated. The respective debtor account will be incorporated as part of the trade debtors or sundry debtors on the balance sheet.

A failure to recognise and account for accruals and prepayments will result in the final accounts for the period not providing a true and fair view of the entity’s performance. Accounting profit will be either overstated or understated. Thus it is necessary at the end of each accounting period or at the end of the accounting year to ensure that all monies due and payable have been correctly recorded, and accounted for in the books of account.

Example

This example is question 2 from May 1997 Accounting & Finance examination paper. The draft final accounts for James Pearson have been prepared and are shown below:

When the draft was checked the following errors were discovered: Returns Outwards of L3,500 had been omitted.

Accrued Wages of L1,300 had not been allowed for.

Depreciation of Motor Vehicle (cost price L6,000) should have been included. The firm’s policy is to provide depreciation at 15 per cent, using the straight line method.

(a) You are to prepare a corrected version of the Trading and Profit and Loss Account for the financial year ended 30 April 1997. (15 marks)

(b) Briefly explain why adjustments are made to accounts and what accounting concept is illustrated. (5 marks)

Suggested Solution

Notes

Undertake the necessary adjustments in accordance with the notes: (i) Returns outwards of 3,500 had been omitted. This reduces the purchases for the period by 33,500.

(ii) Accrued wages of 11,300 had not been allowed for. The wages bill has to be increased by 11,300 since the sum was due and payable for the year.

(iii) Depreciation of motor vehicle (cost price L6,000) should have been included. The policy of IS per cent depreciation has to be applied to the cost of the vehicles. Therefore the annual charge is L900 (L6,000 x 15 per cent).

(a) The corrected version of the Trading and Profit and Loss Account for the financial year ended 30 April 1997.

(b) It is necessary to make adjustments to accounts to ensure that the accounts have been prepared under the underlying principles and concepts enshrined in SSAP2, to ensure the accounts provide a true and fair view of the entity. The accounting concept

illustrated in this question is the matching principle.

David Frederick is a senior lecturer at London Guildhall University’s Department of Management & Professional Development.

Copyright Institute of Credit Management Ltd. Nov 2000

Provided by ProQuest Information and Learning Company. All rights Reserved