Accruals and Prepayments
Accruals are expenses incurred but not yet paid while prepayments are payments for expenses for that are not yet incurred. Accruals and prepayments give rise to current liabilities and current assets respectively in accordance with the matching principle and accrual accounting.
Matching principle requires accountants to record revenues and expenses in the period in which they are incurred regardless of when the relevant payments are made. In order to create this 1-on-1 correspondence between revenue and expenses, expenses are recorded if they are incurred in a particular period even if they are not yet paid, because they were necessary to earn the revenue for that period. On the other hand, prepayments are recorded to represent payments related to goods and services that are to be consumed in future periods. It is this matching principle that differentiates accrual accounting from cash-basis accounting, which records revenues and expenses when they are received and not when they are earned or incurred.
Woodworks, Inc. is a furniture manufacturer and retailer. You are closing the books of the company for the year ended 30 June 2014. Suggest appropriate accounting treatment for the following transactions:
- The company paid salaries of $70,000 for June 2014 on 4 July 2014. Total salaries for the year 2014 do not already include this figure.
- On 5 July 2014, the company received utility bills totaling $30,000.
- Annual rent of $100,000 on Outlet A was paid on 1 January 2014 and it was recorded as prepaid rent.
- Semi-annual rent of $30,000 on Outlet B was also paid on 1 April 2014 and the whole amount was charged to the income statement.
- On 30 June 2014, $50,000 was paid on account of 5-year premium membership of relevant business association.
The basic principle behind accrual accounting is to record revenues and expenses regardless of payment. Following accrual and prepayment adjustments are required for 2014.
- Though salaries of $70,000 were paid on 4 July 2014, they related to services provided by employees in June 2014. These salaries are the cost of June 2014 revenue and must be recorded as part of June financial statements even if the payment is made after 30 June. The following journal entry must be made:
Salaries expense $70,000 Salaries payable $70,000 Salaries payable $70,000 Cash $70,000
- Utility bills related to utilities consumed in June, so they must be reflected in financial statements for the year ended 30 June 2014, even if they are paid later.
Utilities expense $30,000 Utilities payable $30,000 Utilities payable $30,000 Cash $30,000
- 12 months of rent was paid on 1 January 2014 and it was recorded as prepaid rent. Half of this rent is related to the year ended 30 June 2014, so a journal entry should be made to expense out half of the prepaid rent.
Rent expense ($100,000/2) $50,000 Prepaid rent $50,000
- In April 2014, $30,000 was paid on account of six months of rent on Outlet B and it was expensed out. However, only three months of the relevant rent payment belong to financial year 2014. A journal entry should be made to reduce the recorded rent expense and create a prepaid rent asset equivalent to three months of use.
Prepaid rent ($300,000/6×3) $15,000 Rent expense $15,000
- The payment of $50,000 on 30 June 2014 relates to membership fee due in next 5 year. This payment is a prepayment.
Prepaid membership fee $50,000 Cash $50,000
Written by Obaidullah Jan, ACA, CFA <--- Hire me on Upwork