Lecture 4: Accrual and Prepayment PDF

Introduction to Accounting and Finance Lecture 4 Accruals and Prepayment Dr Rosie Cao  Today Lecture MORE INCOME STATEMENT AND BALANCE SHEET Accruals and Prepayments 3  The nature of accruals Illustration (see next slide, graphically):...

Introduction to Accounting and Finance Lecture 4 Accruals and Prepayment Dr Rosie Cao  Today Lecture MORE INCOME STATEMENT AND BALANCE SHEET Accruals and Prepayments 3  The nature of accruals Illustration (see next slide, graphically): – The business may reach the accounting period end without receiving an invoice for an expense which has been incurred. As a consequence, there is no formal obligation to pay and a payable cannot be recorded. – Accruals are recorded to make sure that the expense incurred in the period (but not yet invoiced) is taken into account in the calculation of profit. 4  Accruals & Payables - PAYABLES (CREDITORS): THE AMOUNT OWED BY A FIRM FOR UNPAID INVOICE I.E., Invoice has been received – The firm knows: 1) How much does it owe? 2) Who is the creditor? - ACCRUALS: THE AMOUNT OF EXPENSES OWED BY A FIRM WITHOUT AN INVOICE I.E., Invoice has not been received – The firm DOES NOT know: 1) How much does it owe? 2) Who is the creditor?  Cannot open a payables account 5  Accruals Illustration Regular expense invoiced every 3 months Year-end: in arrears, e.g. electricity No invoice was received for Nov and Dec Expense increases by (2-month bill amount)  Expense in IS Accruals increases by 31.10.X1 31.1.X2 (2-month bill amount) Year end Year end Current liability in 31.12.X0 31.12.X1 Notes: BS - No invoice was received in X1 for November and December. Therefore, there is no formal obligation to pay (the amount may also be unknown) and we cannot record a Payable. But the expense has been incurred because the services have been delivered. 6  Accruals Illustration Expense: increases by (2-month bill amount)  Expense in IS Accruals: increases by (2-month bill amount)  Current liability in BS 7  The role of estimates In some cases, the value of goods or services received before year end (but not invoiced until after year end) will be known. – In these cases the accrual can be made for that amount. In other cases, the value may not be precisely known until the invoice is received. Thus, an estimate of the amount relating to the relevant year has to be made. For example, in the illustration above need to accrue 2 months expense: – this may be based on rate of expense in previous invoice period, but – beware seasonal fluctuations. 8 Example On 31 June 2022, the company received a £420,000 electric bill, usually charged to the administrative costs, covering the period from 31 January 2022 to 30 July 2022. 31 Jan – 31 March  2 months out of the 6 months  £420,000 / 6 * 2 = £140,000 9  Answer Admin cost: increases by (2-month bill amount)  £5,840 + £140 = 5,980  Expense in IS Accruals: increases by (2-month bill amount)  Accruals = £140  Current liability in BS 10 Student activity On 1 June 2021, the company received a £180,000 electric bill, which is normally charged to the administrative costs, covering the period from 1 February 2021 to 30 June 2021 31 Jan – 31 March  2 months out of the 5 months  £180,000 / 5 * 2 = £72,000 11  Answer Admin cost: increases by (2-month bill amount)  £840 + £72 = 912  Expense in IS Accruals: increases by (2-month bill amount)  Accruals = £72  Current liability in BS 12 PREPAYME N TS 13  The nature and composition of prepayments Illustration (see next slide, graphically): – The business may have paid in the current accounting period for goods or services that will be received in the next accounting period. – Prepayments are recorded to make sure that the expense is taken into account in the calculation of profit in the period where it has been incurred (i.e., when the goods or services are received). 14  Prepayment Illustration Regular expense paid in advance every 3 months, Invoice paid in e.g. rent X1 although one month (January) refers to X2 Amount paid for Jan X2 does not belong to X1 31.7.X1 31.10.X1 31.1.X2 Year end Year end 31.12.X0 31.12.X1 Notes Therefore, an expense will be incurred in January X2 but it has been paid in X1. 15  Prepayment Illustration Expense: Decreases by (1-month bill for Jan X2)  Expense in IS Prepayment: increases by (1-month bill for Jan X2)  Current asset in BS 16 Example An internal review revealed that a payment totalling £600,000 for marketing which has been charged to distribution costs covers the period from 31 December 2021 to 30 June 2022 1 April 22 – 30 June 22  3 months out of the 6 months  £600,000 / 6 * 3 = £300,000 17  Answer Distribution cost: decreases by (3-month bill amount)  £6,810 - £300 = £6,510  Expense in IS Prepayment: increases by (2-month bill amount)  Prepayment = £300  Current asset in BS 18 Student activity An internal review revealed that a payment totaling £300,000 for marketing which has been charged to distribution costs covers the period from 1 January 2021 to 30 June 2021 1 April 21 – 30 June 21  3 months out of the 6 months  £300,000 / 6 * 3 = £150,000 19  Answer Distribution cost: decreases by (3-month bill amount)  £1,810 - £150 = £1,660  Expense in IS Prepayment: increases by (3-month bill amount)  Prepayment = £150  Current asset in BS 20  Conclusion Today we looked at: – Accruals and prepayments 21