Accruals and prepayments: worked examples

Method and where the marks are

The matching concept says the income statement should show the expense that belongs to the period, not the cash that happened to be paid. So first separate what you paid from what you used.

Treat the trial balance figure for an expense as "cash paid this year". It is a starting point that usually needs adjusting.

Follow these steps. First, identify whether the item is an expense (rent, insurance, wages, electricity) or income (rent received, commission received). Second, decide the direction of the adjustment.

For an expense, an accrual means you used more than you paid, so add the amount owing. A prepayment means you paid for something you have not yet used, so subtract it.

Third, calculate the charge: cash paid, plus opening prepayment, minus closing prepayment, plus closing accrual, minus opening accrual. It is safer to reason it out each time from what was used than to memorise this line. Fourth, place the closing balances in the statement of financial position.

A closing accrued expense is a current liability. A closing prepaid expense is a current asset.

Take rent. The trial balance shows RM11,000, which is eleven months paid at RM1,000 a month. One more month of RM1,000 is still owing at the year end.

You occupied the premises for twelve months, so the true cost is 11,000 + 1,000 = RM12,000. Add the RM1,000 accrual to reach the income statement charge. The RM1,000 you still owe is a current liability.

Now insurance. You paid RM6,000 covering fifteen months, which is RM400 a month. Three months, RM1,200, relate to next year.

You used only twelve months, so the charge is 6,000 − 1,200 = RM4,800. The RM1,200 prepaid is a current asset, because it is a future benefit already paid for.

Show your workings, because method marks depend on them. Write "cash paid 11,000 + accrual 1,000 = 12,000", not just 12,000. If a ledger account is asked for, put the opening balance on the correct side and enter the bank or cash payment.

Then transfer the year's charge to the income statement and carry down the closing accrual or prepayment. An opening accrual is a credit balance brought down, because you owed it. An opening prepayment is a debit balance brought down, because it was an asset.

Label the transfer to the income statement. A bare figure with no narration often loses the mark.

Marks are mostly lost on three points. The first is reversing the direction, adding a prepayment or subtracting an accrual. Ask "did I use more or less than I paid?"

If more, the expense rises. If less, it falls. The second is putting the balance on the wrong side of the statement of financial position.

Accrued income and prepaid expenses are both assets. Accrued expenses and income received in advance are both liabilities.

The third is time apportionment, such as forgetting a mid-year rent increase. Calculate each part separately and add them, and do not average.

Income received in advance reduces the income shown and creates a liability. It is the mirror image of a prepaid expense.

If you keep adding when you should subtract, we can help. One of our teachers can work through a set of accrual and prepayment questions with you until the "used versus paid" test becomes automatic. Book a trial class