Accruals and Prepayments

Accrual Of Expenses

An accrual is an amount used in one accounting period that that will not be paid until the next accounting period.

In the final accounts accrued expenses are: -

• added to the expense from the trial balance before listing in the Income Statement account
• shown as a current liability in the balance sheet

This is to ensure the Income Statement account records the cost incurred for the year instead of simply the amount paid. The expense is adjusted to relate to the time period covered by the Income Statement account. The balance sheet shows a liability for the amount that is due but unpaid.

Worked Example

Satis Plc has a trial balance showing a debit balance for electricity and gas of £3,000.  Before preparing final accounts an electricity bill for £250 is received on 1 January 2013, i.e. on the 1st day of new financial year As this bill is clearly for electricity used in 2013, an adjustment needs to be made to record this accrued expense for 2013.

In the Income Statement account, the total cost of £3,250 (I.e. £3,000 from the T B. plus £250 accrued) will be recorded as expenses. In the balance sheet £250 will be shown current liability of 'accruals'.

Accruals – Putting them into the accounts

In the accounts, accruals must be shown as an amount owing at the end of the financial year. The electricity and gas account in Satis PLC records will appear as follows:

Dr                                            Electricity and Gas Account        Cr

2013                                         £                                               £         

31 Dec Balance b/d      3000     31 Dec Income Statement       3250

31 Dec Balance c/d        250                                                  _____
                                    3250                                                   3,250

                                                1 Jan Balance b/d                       250

Later on for example on 5 January the electricity bill is paid by cheque and the account for 2014 now appears as:

Dr                             Electricity and Gas Account           Cr

2014                            £                                                  £

5^th Jan    Bank           250       1 Jan Balance b/d            250

The effect of the payment on 5 January is that the account has a 'nil' balance and the bill received on 1 January will not be recorded as an expense in the Income Statement account at the end of 2014.

The effect on profit

Taking note of the accrual of an expense has the effect of reducing a previously reported net profit As the expenses have been increased net profit is less (but there is no effect on gross profit). Thus, the net profit of Satis Plc reduces by £250.

Prepayment of expenses

A prepayment is a payment made in this accounting period but which will not be used until the next accounting period.

A prepayment is the opposite of an accrual: some part of the expense has been paid in advance.  In the final accounts prepaid expenses are: -

• deducted from the expense amount of the trial balance before listing it in the Income Statement account
• shown as a current asset in the year end balance sheet

As with accruals, the reason for this is to ensure that the Income Statement account records the cost incurred

The owner of Satis Plc tells you the trial balance figure for rent and rates of £2000 includes £100 of rent paid in advance for Jan 2014. An adjustment needs to be made for 2013 to record this.

In the Income Statement account, the cost of £1,900 (i.e. £2.000 from the trial balance, less the 100 prepaid) will be recorded as an expense.  In the balance sheet £100 will be shown as a current asset of “prepayments”

Prepayments - the book-keeping records

In the double entry records, prepayments must be shown as an asset at the financial year end. Thus the account for rent and rates in the records of Satis Plc will appear as follows:

Cr                                       Rent and Rates Account                              Dr

2013                                         £                                                           £

31 Dec    Balance b/d                2,000    31 Dec Income Statement     1900

                                                 ____     31 Dec Bal c/d                       100

                                                 2000                                                 2000

2014       1 Jan Balance b/d        100

What effect does this have on profit ?

Prepayment of an expense has the effect of reducing expenses so net profit is greater.

Accruals And Prepayments Of Income

Just as expenses can be accrued or prepaid at the financial year end so can income amounts.

Accrual of income

Here, income of a business is due but unpaid at the financial year. For example, commission receivable might have been earned, but the payment is received after the financial year end, accrual of income is:

• added to the income amount from the trial balance before listing it in the Income Statement account
• shown as a current asset (e.g. commission receivable) in the year end balance sheet

Prepayment of income

Here, the income of a business is paid in advance. For example, rent receivable account could include an advance payment received from tenants. This is:

• deducted from the income from the trial balance before listing it in the Income Statement account
• shown as a current liability (e.g. rent receivable prepaid) in the year end balance sheet

The objective of taking note of accruals and prepayments of income is to ensure that the amount stated in the Income Statement account relates to the period covered by the account.

Opening Balances On Expense Or Income Accounts

There are likely to be 4 separate figures making up the expense or income:

• amount owing or prepaid at the beginning of the year (opening balance)
• amount paid (or received, if an income account) during the course of the year
• amount to be transferred to Income Statement account at the end of the financial year
• amount owing or prepaid at the end of the year (closing balance)

If any three of these are known, the fourth can be calculated, For example, we are given the following information about expenses account for 2013

• owing at beginning of year £35
• amount paid in year £350
• owing at end of year £55

The 'missing' figure here, is the amount transferable to Income Statement account (£370) at year-end, calculated as follows

Dr                 Vehicle Expenses Account                                     Cr

2013                              £        2013                                          £

Bank                            350       1 Jan Balance b/d                     35

31 Dec Balance c/d        55       31 Dec Income Statement       370 
                                    405                                                     405

                                                 1 Jan Bal b/d                             55

Applying these techniques will help you to solve quite complex expenses and income problems set as part of the exam. For example, where an expense account deals with two expenses, such as electricity and gas account, and one expense is prepaid at the year start while the other is accrued!!

PRIVATE EXPENSES AND GOODS FOR OWN USE

Adjustments also have to be made in the final accounts for the amount of any business are used by the owner for private purposes These adjustments are for private expenses and goods for own use,

Private expenses

Sometimes business owners use business facilities for private purposes, e.g. telephone, or car. The owner will agree that part of the expense shall be charged to him or her as drawings, while the other part represents business expense,

Goods for own use

When the owner of a business takes some goods in which the business trades for his/her own use, the double-entry book-keeping is:

debit drawings account                                                           credit purchases account

When working from a trial balance to produce the final accounts, goods for own use should be deducted from purchases and added to drawings.

Reducing Balance Depreciation

Why use another method?

Some assets may have low repair costs in the early years but this may increase as the asset ages.  As a result it may be better to have higher depreciation when repair costs are low and then have lower depreciation costs as repair bills rise.  The reducing balance method attempts to emulate this.

How to calculate it

Cost – Accumulated Depreciation (at start of year) = Net Book Value (NBV)

Reducing Balance method is simply x% of NBV

•          Watch out for the use of 33 1/3% - simply divide the NBV by 3 !!

•          In the first year depreciation figures are the same for both Straight Lines and Reducing Balance methods!

If an non-current asset (machinery) cost £10,000 and was to be depreciated by 20% then the first years depreciation charged to the Income Statement is £2000 (20% of 10000).  In the second year we need to depreciate 20% of £8000.  Don’t forget that NBV is cost minus accumulated depreciation so its £10000 - £2000.

In the second the depreciation charged to the income statement is £1600.  In the balance sheet we would have

Balance sheet (extract)

Non-Current Assets

Machinery at cost                            £10000

Less provision for depreciation         £ 3600

Net Book Value                                                £6400

Next year’s depreciation would be 20% of £6400 (£1280).  Each year the amount of depreciation charged as an expense will be smaller than the last until it is disposed of.

Straight Line Depreciation

Capital Expenditure is expenditure which belongs to more than one accounting period (i.e. a business benefits in more than just that period).  It is then depreciated over its expected lifetime.

Two methods are covered here  – Straight Line and later Reducing Balance

Straight Line

–        1 Simply x% of cost price less any residual value (scrap value)

–        Or

–        2 Using this formula

Cost – Residual Value    =              annual depreciation charge to the

number of years                              Income Statement

In the income statement it would look like this: -

Income Statement (extract)         

Less expenses

Provision for Depreciation                                           xxx

In the Balance Sheet the amount of depreciation for this year is ADDED to the previously outstanding provision to give a new, larger provision of accumulated depreciation which can be put into the new balance sheet.

In other words if an asset is being depreciated by £3000 per year and had a provision of £6000 previously the balance sheet would then show depreciation to now be £9000.  To summarise this is the 3^rd year we have depreciated it (i.e. 9000/3000 = 3 years).  The amount of the cost price less the accumulated depreciation is known as the net book value (NBV) and this is used for reducing balance depreciation and also for calculating the profit or loss on disposal of the asset.

Balance Sheet (extract)

Non Current Assets

Machinery                                  12,000

less Provision for Depreciation      9,000

(Net book Value)                                                     3000

Types of budgets and reasons for using them

This blog covers a number of budgets
Purchases

Production

Trade receivables

Trade payables

Cash budgets (Cash flow forecast)


Budgets are used for a variety of reasons

• To communicate the companies objectives, opportunities and plans to their managers.
• Make organisation aware of its future requirements (raw materials, staffing) to allow planning.
• Delegate responsibilities to managers for tasks / resources without losing control of overall objectives 
• Improve the company’s efficiency

Benefits of budgeting

• Management decisions can be linked to the company’s overall strategy.   
• Standards can be set to try to aid each areas performance.
• Plans can be set in financial terms so costs can be minimalised or possibly avoided entirely (overdraft fees, overtime or additional storage costs).
• Managers can be made responsible for budgets.
• Budgets encourage co-operation and co-ordination between departments.  For example the Production departments should be working closely with the sales department to avoid making items which may not be needed.
• Employees are motivated to achieve objectives which may help to reduce its wastage and reduce costs.  This may be financially encouraged via bonuses etc.
• Control of operations and activities - outcomes compared to the budget using variance analysis techniques.  This means each area can be evaluated in terms of its performance.

However they do have some disadvantages

• Budgets are only as good as the data being used.  If it is too hard to achieve the budget people give up.  If it is too easy to do and people do not need to be pushed hard to achieve them.
• Budgets need to change as circumstances change – but people may work towards their own specific targets rather than overall needs of the company.
• Managers can get too focussed with achieving the budget and forgetting to focus on the real issues of winning customers.  Sales of mortgages before the credit crunch focused on quantity of mortgages sold rather than the customers’ ability to repay.  Profitability suffered as a result.
• Budgeting is a time consuming process in itself costing money to set up and organise.
• Budgets constrains actions – people work to keep to their budget rather than the right long term decision which may exceed the budget but may benefit the company more overall.

Sales Budget

The sales budget should be the first budget created in order to enable an efficient business to work towards meeting customer demands.

Production Budget

The production budget is used to ensure the firm can meet the demands of the sales department.  They then know how many they need to make and why.  Note there will usually be a closing inventory to allow for additional sales.  However it may need to be flexible to avoid a build-up of inventory which could cause wastage.

 

Purchase Budget

If the firm is purchasing items it needs to ensure it has enough to meet demand but avoids any unnecessary wastage

 

Labour Budget

The labour budget enable managers to plan ahead to meet production.  It can be used to maximise efficiency by having staff available at the right times to meet demand and minimising overtime needs.

Trade Payables Budget 

Trade Receivables

 Cash Budget

This ties together all the budgets by putting the inflows and outflows (many of which were calculated in earlier budgets) together to help review the overall cash position of the firm.   Many budgets will include the net inflow for each month.   The figure are probably a lot bigger than this but the principle is the same! Cash budgets are discussed in more detail here.