ACCRUALS AND PREPAYMENTS INTRODUCED

The accruals concept (matching concept)

Financial statements are prepared using the accruals basis of accounting rather than on a cash basis. This means that:

•  sales are recognised in the same period as the related cost of making the sale;

•  income is recognised in the statement of comprehensive income in the same period as the transaction that gave rise to it (not necessarily when cash is paid); and

•  expenses are recognised in the statement of comprehensive income as they arise (not as they are paid).

For example, the cost of rental charges on office accommodation should be spread over the period of time to which the rental payments relate, regardless of when the actual payment of rent occurs.

Illustration: Accruals basis

A business pays annual rental in advance on 1 June each year.
Rent paid on 1 June 2012 = Rs. 240,000
Rent paid on 1 June 2013 = Rs. 300,000
The financial year ends on 30 September.
The rental expense for the year ended 30 September 2013 is:

Period:                                                                                             Rs.

1 October 2012 to 31 May 2013
8/12 of 240,000 (the last 8 months of the rental year)                          160,000
1 June 2013 to 30 September 2013
4/12 of 300,000 (the first 4 months of the rental year)                          100,000
                                                                                                           260,000

Accruals and prepayments

Accruals(accrued expenses)

A business might incur expenses during a period but may not have been sent the invoice by the period end.

Since there has been no payment and no invoice, a financial transaction has not yet occurred and there is not yet anything to record as a book-keeping entry in the ledgers. However, to apply the accruals basis of accounting, the expense must be charged in the statement of comprehensive income for the accounting period to which the expense relates. This is done by creating an accrued expense at the end of the accounting period.

An accrued expense (accrual) is an estimate of the cost that has been incurred in the financial period, and it is included in expenses in the statement of comprehensive income for the period and recognised as a liability (called an accrual) in the statement of financial position.

Accruals are often necessary when expenses are paid in arrears (i.e. at the end of a period of expense).A business might incur an expense before the year end but not receive an invoice until after the year-end. If this is the case the business must estimate the amount of the expense and recognise it as an expense and a liability.

The liability is known as an accrual. The business is said to be making an accrual for the expense or accruing for the expense. There are two approaches to accounting for both accruals

1. The two account approach for accrued expenses (accruals)
2. The one account approach for accrued expenses (accruals)

Prepayments (prepaid expenses)

Prepaid expenses are expenses that are recorded in the accounts in the current period, because a purchase invoice has been received or a payment has been made, but all or part of the expense relates to a future accounting period.

Prepaid expenses occur whenever payments are made in advance for an expense item.

To apply the accruals basis of accounting, the expenses that have been recorded in the accounts but that relate to a future accounting period should be:

q excluded from the expenses in the statement of comprehensive income for the current year and recognised as an asset (a prepayment) at the yearend; and then

q included in the expenses for the next financial period (which is the period to which they relate).

A business might pay or at least be invoiced for some expenses in advance. When the invoice is received the business will recognise the full liability as a debit in an expense account. It would be wrong to then clear all of this to the statement of comprehensive income in the current period. Some of it relates to the next period. This part must be recognised as an asset (it represents a right to receive some kind of service in the next period) called a prepayment. There are two approaches to accounting for prepayments:

•  Method 1 – using two accounts; and

•  Method 2 – using one account.

Example:
Wasif set up in business on 1 January Year 1. The business has a 31 December year end.
The business acquired a telephone system on 1 February.
Telephone charges are paid every 3 three months in arrears and telephone invoices received in Year 1 are as follows:
                                   Rs.
30 April                      5,000
31 July 7,                       500
31 October                 8,500
To calculate the telephone expenses for Year 1, it is necessary to estimate the expense for November and December, and to make an accrual.
The next invoice (at the end of January Year 2) is expected to be Rs. 9,000.
The accrual for November and December Year 1 should be Rs. 6,000 (Rs. 9,000 ×
2/3).
This can be represented as follows:

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