Accruals and prepayments - Year-end adjustments and reversal...

Learning Outcomes

After studying this article, you will be able to apply the accruals concept to expenses and incomes, calculate and record accruals and prepayments at the year-end, prepare the required journal entries including reversals, and explain their effect on the statement of profit or loss and statement of financial position. You will also recognise common errors and understand correct presentation in financial statements.

ACCA Maintaining Financial Records (FA2) Syllabus

For ACCA Maintaining Financial Records (FA2), you are required to understand how accruals and prepayments ensure expenses and incomes are matched to the correct accounting period, and how to process all related year-end and reversal entries. In your revision, focus on:

• The accruals basis of accounting and its application to expenses and incomes
• Determining and calculating necessary year-end accruals and prepayments
• Preparing journal entries and updating the general ledger for accruals, prepayments, and their reversal
• Reporting accruals and prepayments correctly in the statement of profit or loss and statement of financial position
• Explaining the effect of accrual and prepayment adjustments on net profit, assets, and liabilities

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which accounting concept ensures that expenses are recorded in the period in which they are incurred, not necessarily when paid?
   1. Prudence
   2. Accruals
   3. Consistency
   4. Going concern

2. True or False? A prepayment at year-end reduces the expense shown in the current year's statement of profit or loss.

3. A business pays insurance of $1,200 on 1 November for twelve months. What is the prepayment at 31 December?

4. When should an accrual raised at the previous year-end be reversed?

5. Why is it necessary to reverse accruals and prepayments at the start of the next accounting period?

Introduction

The accruals concept requires businesses to charge each accounting period with the expenses and income that relate to it, no matter when cash is actually paid or received. At the end of each period, adjustments for accruals and prepayments ensure that reported profits are not overstated or understated.

Misstating these adjustments will lead to errors in the financial statements, affecting profit, assets, and liabilities. Journal entries are required at the period-end to account for any outstanding or prepaid expenses (or income)—and, crucially, these balances must be reversed or cleared in the following period.

Key Term: accruals concept
The principle that income and expenses are recognised in the period to which they relate, regardless of when cash is received or paid.

Key Term: accrual
An expense or income that is recognised in the current period but is not yet paid or received at the period-end.

Key Term: prepayment
An expense paid in advance, or income received in advance, for a future period after the current accounting period.

Year-End Adjustments for Accruals and Prepayments

Adjusting for Accrued Expenses

Expenditure like utilities, salaries, or services often relates to a specific period but invoices may not have arrived by the year-end. To match costs to the period, you must record an accrual for any unpaid portion.

Double-entry:

• Debit the relevant expense account (to increase the expense in the statement of profit or loss)
• Credit an accruals liability account (reported as a current liability)

This ensures the full cost incurred is recognised even if payment is made later.

Adjusting for Prepaid Expenses

When payments are made in advance for goods or services to be received in the next period (e.g. insurance, rent), the prepaid portion does not relate to the current period and should be removed from the expense.

Double-entry:

• Debit a prepayments asset account (reported as a current asset)
• Credit the relevant expense account (to reduce the expense in the statement of profit or loss)

This keeps only the correct portion as an expense and recognises the advance payment as an asset.

Key Term: statement of profit or loss
A financial statement showing income and expenses for the period, resulting in net profit or loss.

Key Term: statement of financial position
A financial statement reporting assets, liabilities, and capital at a specific date.

Accrued and Deferred Income

The same logic applies to income. Income earned but not yet invoiced at period-end is accrued (asset). Income received in advance is deferred (liability).

Worked Example 1.1

A business pays $2,400 for annual insurance on 1 October, covering the period to 30 September next year. The year-end is 31 December. What are the adjustment and year-end balances?

Answer:
Annual payment: $2,400 (for 12 months) = $200 per month. Coverage in current year: October–December = 3 months = $600 expense. Prepaid (Jan–Sep next year): 9 months = $1,800.

Journal at 31 December:

• Debit Insurance expense $600
• Debit Prepayments (asset) $1,800
• Credit Cash/Bank $2,400

Worked Example 1.2

A telephone bill for $150 is received after the year-end for charges relating to December. The business has a 31 December year-end.

Answer:
The cost related to the current year is not yet recorded.

Journal at 31 December:

• Debit Telephone expense $150
• Credit Accruals (liability) $150

Reversal of Accruals and Prepayments at Start of Next Period

Year-end accruals and prepayments are brought forward as opening balances in the next accounting period. If not reversed, expense/income will be double-counted when the actual payment or receipt is processed.

The standard practice is to reverse these balances at the start of the new period. This is usually achieved by posting the opposite entry, so that when the bill is paid or invoice is raised, it is recorded only once in the profit or loss for the new period.

Example for reversal:

• If an accrual for an expense was credited to accruals last year, at the start of this year:
  • Debit Accruals
  • Credit Expense

This clears the brought-forward accrual from the expense account for the new period.

Key Term: reversal
The process of posting a journal at the start of a new accounting period to cancel the effect of a year-end accrual or prepayment and prevent double-counting.

Worked Example 1.3

An accrual of $500 for electricity at 31 December is reversed on 1 January. In February, the actual invoice for $500 is received and paid. What are the total expense entries in the new year?

Answer:
1 January (reversal):

• Debit Accruals $500
• Credit Electricity expense $500

When invoice is paid:

• Debit Electricity expense $500
• Credit Cash/Bank $500

Net effect: Only the true cash amount is recorded as current year expense, with no double-counting.

Exam Warning

Exam Warning Forgetting to reverse accruals or prepayments at the start of the new period can result in over- or understated expenses or income. Always check if reversals are required in scenario questions.

Impact on Financial Statements

• Profit or Loss:
  Accruals increase expenses (reduce profit). Prepayments decrease expenses (increase profit).
• Financial Position:
  Accruals are reported as current liabilities. Prepayments as current assets.

Incorrect adjustments will misstate both profit and net assets.

Revision Tip

Revision Tip Always reconcile cash payments to the period they relate to. Create a simple timeline of payment date, period covered, and accounting year-end when answering exam questions.

Summary

Accruals and prepayments ensure costs and income are matched to the correct period, preventing misstatement of profit and position. Accurate journal entries at year-end and timely reversals at the start of the next period guarantee that transactions are recorded once, and in the correct year.

Key Point Checklist

This article has covered the following key knowledge points:

• Define accruals concept, accrual, and prepayment
• Calculate and record year-end accruals and prepayments
• Prepare year-end adjustment and reversal journals
• Describe the effects on both profit or loss and the statement of financial position
• Recognise the need to reverse balances at the start of the new accounting period

Key Terms and Concepts

• accruals concept
• accrual
• prepayment
• statement of profit or loss
• statement of financial position
• reversal