Chapter 11
Accruals, Prepayments, Accrued and Deferred Income
#Accrual Accounting
Accrual accounting concerns the timing of the recognition of transactions. Under accrual accounting, the statement of profit or loss must include all income and expenses related to the period, regardless of the timing of cash receipts or payments.
The mismatches between the timing of transactions and their cash flow give rise to the following in the statement of financial position:
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Key Point |
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Under accruals accounting, revenue and costs are both: accrued (recognised as earned or incurred) and recorded in the financial statements of the period they relate. |
The matching concept requires expenses incurred in generating revenue to be matched against the revenue in determining profit or loss for the period.
- When revenue is recognised because it has been earned, the costs incurred in generating such revenue are also recognised (matched).
- However, a future sale cannotbe recognised merely because it can be matched with costs incurred. This would be contrary to accruals accounting and the concept of prudence (which calls for the exercise of caution so that, for example, income is not overstated).
Accruals accounting is applied to:
Trade Receivables and Trade Payables
When goods or services for resale are sold or bought on credit, the sale or the purchase is recorded immediately, and trade receivables and trade payables are created. As a result, the income (Sales) and expense (Purchases) is recognised even though there has been no actual payment.
Business Expenses and Income
The same logic used for credit sales and purchase transactions is applied to other expenses or income of the business, such as rental, electricity and insurance fees.
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Example 1 |
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Desmond owns a business that makes made-to-measure wooden window frames, doors and furniture. The business is known as DPQ Joinery, and all the wooden furniture is made at a single workshop premise that the business owns. Any painting required is done at a separate workshop space, which the business rents. The office where all the accounting and administrative functions are carried out is attached to the business’s workshop premises. DPQ Joinery would most likely incur numerous expenses to operate his business, such as wages, electricity, repairs, maintenance, telephone, insurance, rental of the painting workshop, advertising and stationery. Broadly, expenses can be split into two categories: ·        Those related to a specific transaction on a particular date, for example, stationery. ·        Those related to an ongoing service received over time, for example, electricity, rent or telephone service. For example, DPQ Joinery uses electricity daily, incurring an expense. However, the electricity supplier may only invoice DPQ Joinery each quarter for the electricity used over the past three months. At DPQ Joinery’s year-end, the business will owe the electricity supplier for electricity used but not yet invoiced. This used but unpaid electricity will need to be accrued to ensure that the total cost of the electricity used in the year is reflected in the profit figure within the statement of profit or loss. The business expense reflected in the final accounts should be based on the electricity use rather than how much has been invoiced or paid. Electricity was used as an example, but the same logic applies to other business expenses with ongoing use – such as telephone service, rent or insurance. |
#Accruals Accounting on Accruals, Prepayments, Accrued Income and Deferred Income
Payment received from income and made for expenses may be made in arrears (received/paid later) or in advance (received/paid earlier).
This chapter discusses accruals, prepayments, accrued income and deferred income. The journal entries below will only be made at the financial year-end.
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Category |
Explanation |
Asset |
Liability |
Journal Entry |
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Accruals |
Expenses incurred before invoice received/ payment made |
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✓ |
DR Expenses CR Accruals |
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Prepayments |
Invoice received/ payment made before Expenses incurred |
✓ |
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DR Prepayments CR Expenses |
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Accrued Income |
Income earned before being invoiced/ payment received |
✓ |
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DR Accrued Income CR Income |
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Deferred Income |
Invoiced/ payment received before Income earned |
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✓ |
DR Income CR Deferred Income |
A business may incur expenses with payments/ invoices made in arrears or in advance:
Accruals are expenses invoiced/paid in arrears. For example, for a business with a year-end date of 31 January, electricity incurred from January to March is invoiced only at the end of March. In this example, the electricity accrual at the year-end will relate to the period 1 to 31 January. Accruals are reported as a liability in the statement of financial position and are a consequence of when the year-end date is.
Prepayments are expenses invoiced/paid in advance. For example, for a business with a year-end date of 31 December, the following year’s business insurance is invoiced once at the end of the current year e.g. 20X4. In this example, the insurance prepayment at the year-end 31 December 20X4 will relate to the following year-ending 31 December 20X5. Prepayments are reported as an asset in the statement of financial position and are a consequence of when the year-end date is.
A business may generate income with invoices issued/payments received in arrears or in advance:
Accrued Income is income generated for invoices issued/payments received in arrears. For example, a business with a year-end date of 31 July, may rent out additional space in an office and collect rental income at the end of the month. In this example, accrued rental income at the year-end will relate to the period 1 – 31 July. Accrued income is reported as an asset in the statement of financial position and is a consequence of when the year-end date is.
Deferred Income is income generated with invoices issued/ payments received in advance. For example, a business with a year-end date of 30 April, may collect rental income in advance for the following month. In this example, deferred rental income at the year-end, e.g. 30 April 20X4, will relate to the period 1 – 31 May 20X4. Deferred income is reported as a liability in the statement of financial position and is a consequence of when the year-end date is.
#What is an Accrual?
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Key Point |
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An accrual is recognised when an expense incurred has not been paid or invoiced for by the end of the financial period. |
Usually, a business recognises an expense when it receives a purchase invoice (credit purchase) or makes a payment (cash purchase); the journal entry would be DR Expenses, CR Payables/Bank.
However, certain ongoing expenses may only be invoiced after the services have been incurred. This is known as a payment in arrears. The expense that has yet to be invoiced at year-end is recognised as an accrual.
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Example 2 |
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DPQ Joinery’s electricity supplier sends its invoice every quarter (three months). The quarterly invoice will be for the electricity used in the previous quarter (three months). This means that the electricity supplier will invoice DPQ Joinery after it has used the electricity. This is known as invoicing in arrears. At the year-end, DPQ Joinery will owe the electricity supplier for electricity used since the last invoice date. A liability, therefore, needs to be recorded in the statement of financial position to reflect the amount owed. This liability is an accrual, which will also be recorded in the electricity expense account. |
#Accounting for Accruals
Once the accrual amount is established, the amount is recognised as an expense and a liability.
At year-end, the business will adjust for accruals creation for expenses incurred before receiving the invoice/making payment.
In the subsequent accounting period, where the business receives the invoice and makes the payment, it will reverse the accruals and account for the expense payment. The accruals creation and the reversal of accruals are posted to the relevant ledgers using journals.
The manual journal entry for creating accruals at year-end to recognise the expense incurred that has not been paid is:
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General Ledger Account |
Category |
Explanation |
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DR |
Individual expense |
Expense |
Expenses increased |
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CR |
Accruals |
Liability |
Accruals (liability) increased |
The adjustment for accruals creation will have an impact on the business’s profits and net assets as follows:
Profits – The journal entry to create accruals is to debit the expenses account. Expenses increases, which will lead to a reduced profit figure.
Net assets – The corresponding entry is to credit the Accruals liability account. Net assets or capital is the assets less liabilities of a business. Since liability has increased, the net assets of the business will decrease.
In the next accounting period, the supplier will invoice the business for the expense, and the business will make payment. As a result, manual journal entries are made for:
the accruals reversal
the expense payment
The journal entry to reverse the accruals adjustment is:
| Â |
General Ledger Account |
Category |
Explanation |
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DR |
Accruals |
Liability |
Accruals (liability) decreased |
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CR |
Individual Expense |
Expense |
Expense decreased |
The journal entry for the expense payment is:
| Â |
General Ledger Account |
Category |
Explanation |
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DR |
Individual expense |
Expense |
Expense is recorded (increased) |
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CR |
Bank/ Payables |
Asset |
Bank (asset) decreased |
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Example 3 |
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During the year ended 31 December 20X2, the electricity supplier sent the following invoices to DPQ Joinery, which were paid immediately:
DPQ Joinery paid a total of $21,880 for electricity during the year. However, this relates only to the electricity used by the business from 1 January to 31 October. An additional two months of electricity use (1 November to 31 December) have not been invoiced and paid. At year-end 31st December 20X2, DPQ Joinery needs to adjust for Accrual creation. There are two options to calculate the value of the Accrual: Calculate the accrual amount based on the invoice for the same period last year (This will reflect consumption at the same time of year). Calculate the accrual amount based on the last invoice received. Note: Since there is no information on the last year’s invoice for the same period, DPQ Joinery will use the previous invoice received. The last invoice received was $7,230 and relates to electricity use for August to October. However, we only need to make an accrual for two months (November and December) of electricity use. From the last invoice, The average cost for one month: $7,230 ÷ 3 months = $2,410 Therefore, two months’ worth of electricity: $2,410 × 2 months = $4,820 So, the estimated value of the accrual required to be created at year-end: $4,820
The debit to the expense account increases the expense for the year. As a result, this accrual adjustment will reduce profits during the year. The impact of the accruals creation adjustment to the general ledger accounts for the year is as follows (assuming no opening balance in the Accruals account):
In this example, we assumed there is no opening accrual on 1 January 20X2 for electricity expenses, meaning there is no accrual balance at 31 December 20X1. This is slightly unrealistic because electricity expense is paid in arrears, and there should be an accrual balance at the end of each accounting period. In this scenario, the closing accruals balance of $4,820 is the following period’s opening accruals balance. |
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Example 4 (with opening balance) |
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DPQ Joinery’s employees are paid on an hourly basis. The employees are paid once a week in arrears for hours worked in the previous week. The year-end is 31 December 20X2. At the end of the year, DPQ Joinery owes its employees a week’s worth of wages for the hours that they have worked. During the year-ended 20X2, DPQ Joinery has the following information: At the end of 20X1, DPQ Joinery owed its employees $1,560 for wages. On 31 Dec 20X1, the manual journal entry is made to create an accrual.
The accrual balance of $1,560 is brought forward in 20X2 as an opening balance. The expense is transferred to the profit or loss for the year and not brought forward to the following period. DPQ Joinery paid $1,560 due to its employees on the first week of 20X2. Since DPQ Joinery has paid its employees in the current financial period for opening accruals balance, we will reverse the accrual balance in 20X2 as DPQ Joinery no longer owes that balance to its employees. The expense payment of $1,560 is then recorded. The accrual adjustment is reversed:
The payment of expenses is recorded:
In weeks 2 to 52 of 20X2, a further $84,934 of wages was paid to the employees. The payment of expenses is recorded as follows:
At the end of 20X2, the business owes its employees $1,790 for wages. At the end of 20X2, DPQ Joinery creates an accrual for the balance owed to its employees who have not been paid.
The impact of the accruals adjustment to the general ledger accounts is as follows:
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Example 5 |
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Anne owns a business with an accounting year-end of 30 September 20X5. A lease on office premises is taken on 1 January 20X5. Rent for the year to 31 December 20X5 is $2,400. On 1 January 20X5, $1,000 was paid regarding rent due. For the year-ended 30 Sept 20X5 (Year 1): The Year 1 financial period is from 1 October 20X4 to 30 Sept 20X5, while the lease rental period is from 1 Jan X5 to 31 Dec X5. On 1 Jan X5, Anne paid rent of $1,000. The journal entry to record the expense payment is:
At year-end 30 Sept X5, the portion of rental expense used but not paid is recognised as an accrual. The lease on office premises was taken from 1 Jan X5 to 31 Dec X5. On 30 Sept X5, Anne incurred 9 months of expense ($2,400 × 9/12 months) = $1,800. Anne paid $1,000 at the start of the lease period; the total expense incurred but not paid is $800 ($1,800 − $1,000). The journal entry to create the accrual is:
The ledger account during the financial year-end 30 Sept 20X5 will show the following after the journal entries have been recorded.
For the year-ended 30 Sept 20X6 (Year 2): The Year 2 financial period is from 1 October 20X5 to 30 Sept 20X6, while the rental lease period is from 1 Jan X6 to 31 Dec X6. Anne pays rent on the office building lease of $1,400 on 31 Dec 20X5. The journal entry to record the lease payment on 31 Dec X5 is:
The rental for the lease for the first year would have been paid in total ($1,000 + $1,400) = $2,400. On 31 December 20X5, the accruals made of $800 in the previous year would have been incurred. The accruals adjustment will be reversed:
Anne has identified that the rent for the year to 31 December 20X6 is $2,800. On 15 June 20X6, she pays rent of $1,400. The journal entry to account for the rental payment of $1,400 on 15 June X6 is:
At the year-end of 30 Sept X6, Anne will adjust for accruals for rental expenses incurred but not paid. The expense incurred for the year is $2,800 × 9/12 months = $2,100. Only $1,400 has been paid in respect of this expense. Therefore $700 ($2,100 − $1,400). The journal entry is:
The ledger accounts during the financial year-end 30 Sept 20X6 will show the following after the journal entries have been recorded.
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Activity 1
The accounting year end is 31 December 20X6. A gas bill for $300 arrives on 2 February 20X7 for the quarter to 31 January 20X7.
Show the 31 December 20X6 ledger entries for the accrued expense.
#What is a Prepayment?
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Key Point |
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A Prepayment is recognised when a business pays in the current financial period for an expense that relates to the next financial period. |
A business recognises an expense when it receives an invoice and makes payment. However, certain expenses may be invoiced and paid before they are incurred. This is known as a payment in advance. The amount paid for expenses not yet incurred is recognised as a prepayment.
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Example 6 |
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DPQ Joinery rents a workshop and pays rent quarterly in advance. This means payment must be made on the first day of each rental period. This payment is for the rental expense for the next three months. The business started renting this workshop on 1 June 20X2. So far, the following invoices for rent have been received and paid:
In 20X2, a total of $3,600 is paid for rent covering the period from 1 June 20X2 to 28 February 20X3. Some of this payment relates to 20X3, so if the total amount of $3,600 were included as the rent expense for 20X2, then it would be overstated. In this situation, you need to reduce the expense. This reduction to the expense is known as a prepayment. |
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Example 7 |
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The accounting year-end is 30 June. Insurance on the business property runs from 1 October to 30 September and is paid annually in advance.
 What is the insurance expense for the year ended 30 June 20X7? Consider the timeline: The expense for the accounting period under consideration must include all the amounts which accrue to (belong in) the year to 30 June 20X7:
Note: Because $1,800 was paid in advance, there will be a prepayment of $450 on 30 June 20X7. This is recognised as a current asset, increasing net assets/capital in the statement of financial position and profit (by reducing the expense).  Accounting for Prepayments During the year, the business makes payments/ receives invoices for expenses not yet incurred and records expense payments. At year-end, the business identifies which payments were made for expenses not yet incurred. Since expenses are not incurred in the year, an adjustment for prepayment creation is made (credits/reduces expenses). When the business continues using the expenses in the next accounting period, it will adjust for prepayment reversal. In a financial year, a supplier sends invoices to the business, and the business makes payments for the expenses. However, at year-end, it is identified that the amount paid does not relate to expenses incurred during the year. Therefore, a prepayment is recognised to reduce the expense charge for the year. During the year, two entries occur for payments of expenses not yet incurred: recording the expense creating the prepayment The journal entry for the expense booking is:
The above journal entry reflects the business paying the expense in cash to the supplier. (Note – it doesn’t matter whether the invoice from the supplier has been paid or not. The important thing is that an expense has been recognised in the system that relates to a future period). The manual journal entry for prepayment creation is:
Since expenses have been recognised earlier, although they have not yet been incurred (only incurred in the next accounting period), a prepayment is created to reduce the expense charge during the year. The adjustment for prepayment creation will have an impact on the business’s profits and net assets as follows: • Profits – The journal entry to create a prepayment is to credit the expenses account. Expenses decrease, which will lead to an increased profit figure. Net Assets – the corresponding entry is to debit the Prepayment account. Net assets or capital is the assets less liabilities of a business. Since assets have increased, the business’s net assets will also increase. In the next accounting period, the business incurs expenses as the period progresses. Therefore, the business records the reversal of the prepayment made in the previous period. Thus, the Prepayment account is reversed, and the expense is recorded. The manual journal entry for the reversal of the prepayment is:
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Activity 2 During the year ended 30 June 20X5, a business pays $5,905 for electricity to cover the opening accrual of $590 and the invoices received during the year. The last invoice was $1,860 and covered the period from 1 March 20X5 until 31 May 20X5. What should the expense be in the Statement of Profit or Loss for the year ended 30 June 20X5? During the year ended 30 September 20X7, a business paid $10,200 for insurance to cover the period from 1 July 20X7 to 30 June 20X8. The opening prepayment for insurance expenses was $6,850. What should the expense be in the Statement of Profit or Loss for the year ended 30 September 20X7? |
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#What is Accrued and Deferred Income?
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Key Point |
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Accrued income is recognised when a business receives/invoices its income in arrears after earning it. At year-end, the business has earned income that has not been received. Deferred income is recognised when a business receives/invoices its income before earning it. At year-end, the business received a payment related to the following year. |
Accruals and prepayments are liabilities and assets recognised during year-end due to payment of expenses in arrears or in advance.
Accrued and deferred (prepaid) incomes are assets and liabilities recognised during year-end due to income receipts in arrears or in advance.
Accrued income is recognised as an asset to reflect the income owed to the business since revenue has been provided but invoice/payment has not yet been issued/ received. (receipt in arrears).
Deferred income is recognised as a liability as payment has been received for revenue not yet provided. (receipt in advance)
#Accounting for Accrued Income
At year-end, the business will adjust for accrued income creation for income generated for payments in arrears.
The journal entry for the accrued income is:
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General Ledger Account |
Category |
Explanation |
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DR |
Accrued income |
Asset |
Accrued income (asset) increased |
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CR |
Revenue/ income |
Income |
Income has increased |
The income calculated for the current financial year where payment has not been received is recognised as an asset (accrued income).
The adjustment for accrued income will have an impact on the business’s profits and net assets as follows:
Profits – The journal entry to create accrued income is to credit the income account. Income increases, which will lead to an increased profit figure.
Net assets – The corresponding entry is to debit the accrued income asset account. Net assets or capital is the assets less liabilities of a business. Since assets have increased, the net assets of the business will increase.
In the next financial period where payment has been received, the business will reverse the accrued income adjustment made in the previous period and record the income receipt.
Reversal of accrued income:
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General Ledger Account |
Category |
Explanation |
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DR |
Revenue/ income |
Income |
Income has decreased |
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CR |
Accrued income account |
Asset |
Accrued income (asset) decreased |
Record of Income Receipt:
| Â |
General Ledger Account |
Category |
Explanation |
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DR |
Bank account |
Asset |
Bank (Asset) increased |
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CR |
Individual Income Account |
Income |
Income has increased |
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#Accounting for Deferred Income
At year-end, the business will adjust for deferred/prepaid income for income generated for payments in advance.
Payment has been received in the current financial period for income generated in the following financial period. The business records the income receipt during the year, then calculates and creates the deferred income amount adjustment.
Record of income receipt:
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General Ledger Account |
Category |
Explanation |
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DR |
Bank account |
Asset |
Bank (asset) increased |
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CR |
Revenue/ income |
Income |
Income has increased |
The journal entry for deferred income creation is:
| Â |
General Ledger Account |
Category |
Explanation |
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DR |
Revenue/ income |
Income |
Income has decreased |
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CR |
Deferred income |
Liability |
Deferred income (liability) increased |
The adjustment for deferred income will have an impact on the business’s profits and net assets as follows:
Profits – The journal entry to create deferred income is to debit the income account. Income decreases, which will lead to a decreased profit figure.
Net assets – The corresponding entry is to credit the deferred income liability account. Net assets or capital is the assets less liabilities of a business. Since liabilities have increased, the net assets of the business will decrease.
As the months progress, the business will generate income in the following accounting period. Accordingly, it will record deferred income reversal.
The journal entry for the reversal of deferred income is:
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General Ledger Account |
Category |
Explanation |
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DR |
Deferred Income |
Liability |
Deferred Income (Liability) decreased |
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CR |
Revenue/ income |
Income |
Income has increased |
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Example 10 |
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DAHS Co rents out two properties that it owns. Its year-end is 30 June 20X6. Payment for both properties is made every three months (every quarter). For property 1, the rent is received in advance. The rent is $5,400 per quarter, and the last receipt was for the three months of 1 May to 31 July 20X6. For property 2, the rent received is in arrears. The rent is $3,600 per quarter, and the last receipt was for the three months of 1 February to 30 April 20X6.
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