FA! chapter 1

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Chapter 1 Accruals and Prepayments

Notes to teachers

1 Start with Chapter 4 of Frank Woods Introduction to Accounting and briefly explain to students how torecord expenses and other revenues in the cash book and post entries to the general ledger.

2 Refer to Chapter 10 of Frank Woods Introduction to Accounting and briefly explain to students theaccrual concept.

3 Explain the meaning of accrued expenses, prepaid expenses, accrued revenues and unearned revenues with the aid of real-l ife examples, and why they are treated as current assets or current liabilities.

4 Students should know the alternative names of the above items.

5 Most students have difficulty understanding why accrued revenues and unearned revenues are treated as

current assets and current liabilities, respectively. Teachers should clarify the meaning of current assetsand current liabilities by doing Try This Activity A3 and A7 with students.

6 If the entries in the accounts of expenses and other revenues are posted from the cash book, they are saidto be made on a cash basis. Students should know that the accrual concept is one of the fundamentalprinciples underlying financial reporting. To correspond with the accrual concept, adjustments arerequired in the accounts of expenses and other revenues at the end of an accounting period. As a result,financial statements can then be prepared on an accrual basis.

7 Two methods are used to adjust for accruals and prepayments. Students should master both methods.

8 Timing is very important in deciding whether an item and how much of an item is accrued or prepaid.Teachers always need to remind students to note the financial years closing date.

Q1 According to the accrual concept, a firm should only record revenues generated by goods sold or servicesrendered during a period, rather than the amounts actually received during that period. Similarly, a firmshould only record expenses which have been incurred in generating those revenues during the sameperiod, rather than the amounts actually paid during that period.

Q2 Under cash accounting, revenues are recognised when received and expenses are recognised when paid.Under accrual accounting, revenues are recognised when earned and expenses are recognised whenincurred.

Q3 Accruals refer to expenses that have been incurred during a period but have not been paid by the end of that period. Accruals can also refer to revenues that have been earned during a period but have not beenreceived by the end of that period.

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Q4 Prepayments refer to expenses that have been paid during a period but have not been incurred by theend of that period. Prepayments can also refer to revenues that have been received during a period buthave not been earned by the end of that period.

Q5 Accrued expenses are liabilities of the firm and therefore the accrued expense account should beclassified as a real account.

Q6 Accrued revenues are assets of the firm and therefore the accrued revenue account should be classified asa real account.

Q7 Accrued Water Charges

2010 $ 2010 $Jan 1 Water charges 1,240 Jan 1 Balance b/f 1,240

Water Charges

2010 $Jan 1 Accrued water charges 1,240

Accrued Interest Revenue

2010 $ 2010 $Jan 1 Balance b/f 1,600 Jan 1 Interest revenue 1,600

Interest Revenue

2010 $Jan 1 Accrued interest revenue 1,600

A1 This is because accrued expenses are liabilities that are expected to be repaid within one year.

A2 Total expenses for the period will be understated and the net profit for the period will be overstated.

A3 This is because accrued revenues are assets that are expected to be converted into cash within one year.

A4 Total revenues for the period will be understated and the net profit for the period will also beunderstated.

A5 This is because prepaid expenses represent goods or services that are expected to be consumed withinone year.

A6 Total expenses for the period will be overstated and the net profit for the period will be understated.

A7 This is because unearned revenues represent goods or services that a business has to provide to itscustomers within one year.

A8 Total revenues for the period will be overstated and the net profit for the period will also be overstated.


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A9 K HuiIncome Statement for the year ended 31 March 2010 (extract)

$Other revenues:Rent revenue 80,000Commission revenue 2,680

Expenses:Rent expense 100,000Telephone expense 1,140

A10 Insurance

2009 $ 2009Feb 26 Bank 1,800 Dec 31 Profit and loss 3,000 Aug 24 Bank 1,800 " 31 Prepaid insurance 6

3,600 3,602010Jan 1 Prepaid insurance 600

Prepaid Insurance

2009 $ 2009Dec 31 Insurance 600 Dec 31 Balance c/f 6002010 2010Jan 1 Balance b/f 600 Jan 1 Insurance 600

Rent Revenue

2009 $ 2009Dec 31 Profit and loss 30,000 Sept 24 Bank 10,000

" 31 Unearned rent revenue 10,000 Oct 25 Bank 10,00Nov 26 Bank 10,00Dec 28 Bank 10,00

40,000 40,002010Jan 1 Unearned rent revenue 10,00

Unearned Rent Revenue2009 $ 2009Dec 31 Balance c/f 10,000 Dec 31 Rent revenue 10,0002010 2010Jan 1 Rent revenue 10,000 Jan 1 Balance b/f 10,000

A11 In the income statement:

Net profit for the year would be total revenues received minus total expenses paid during the year. Sales would be the amount actually received from sales during the year. Discounts allowed would

not be separately shown.

Purchases would be the amount actually paid for purchases during the year. Discounts received would not be separately shown.

The matching concept (which will be explained in Chapter 17 of Frank Woods Financial Accounting 2 ) would no longer apply. Therefore, no adjustments for opening/closing inventory would be required.

Rent received in advance would be recognised as revenue for the year. Interest revenue would not be recognised as revenue for the year because it had not been received

by the year end.

No adjustments for accrued wages and prepaid telephone charges would be required.


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In the balance sheet:

The items inventory, accounts receivable, accrued revenues and prepaid expenses would notappear in current assets.

The items accounts payable, accrued expenses and unearned revenues would not appear incurrent liabilities.

A13 Accrual accounting can more accurately measure the financial performance (i.e., profitability andliquidity) of an entity.

Under cash accounting, revenues represent the amounts received during an accounting period, whether they have been earned or not. The amounts earned but not yet received would not be recorded asrevenues while the amounts received but not yet earned would not be excluded and not treated asrevenues.

Under accrual accounting, revenues represent the amounts earned during an accounting period, whether they have been received or not. The amounts earned but not yet received or received but not yet earned

would be shown as current assets and liabilities, respectively, in the balance sheet.

Likewise, under cash accounting, expenses represent the amounts paid during an accounting period, whether they have been incurred or not. The amounts incurred but not yet paid would not be recordedas expenses while the amounts paid but not yet incurred would not be excluded and not treated asexpenses for the period.

Under accrual accounting, expenses represent the amounts incurred during an accounting period, whether they have been paid or not. The amounts paid but not yet incurred or incurred but not yet paid would be shown as current assets and liabilities, respectively, in the balance sheet.

A SSESSMENT

Short QuestionsShort Questions

1 (i) Rent2008 $ 2008 $Dec 31 Bank 16,000 Dec 31 Profit and loss 20,000

" 31 Accrued c/f 4,00020,000 20,000

(ii) Insurance2008 $ 2008 $Dec 31 Bank 900 Dec 31 Profit and loss 635

" 31 Prepaid c/f 265900 900

(iii) Rates2008 $ 2008 $Jan 1 Bank 750 Dec 31 Profit and loss 1,500Jul 1 Bank 1,125 " 31 Prepaid c/f ($1,125 ) 37

1,875 1,875

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(iv) Rent Revenue2008 $ 2008Dec 31 Profit and loss ($4,000 12) 48,000 Apr 15 Bank 20,00

" 31 In advance c/f 16,000 Dec 15 Bank 44,064,000 64,00

2X (i) General Expenses2009 $ 2009Mar 31 Bank 6,150 Mar 31 Profit and loss 5,590

" 31 Prepaid c/f6,150 6,15

(ii) Commission Revenue2009 $ 2009Mar 31 Profit and loss 3,231 Mar 31 Bank 3,05

" 31 Accrued c/f3,231 3,23

(iii) Carriage Outwards2009 $ 2009Mar 31 Bank 666 Mar 31 Profit and loss 7

" 31 Accrued c/f 122788 7

(iv) Insurance2008 $ 2009 Apr 1 Bank 1,080 Mar 31 Profit and loss 1,442009 " 31 Prepaid c/f ($1,080 69) 720Jan 1 Bank 1,080

2,160 2,16

3 (i) Rent Accrued Rent2008 $ 2008 $ 2008 $ 2008Dec 31 Bank 16,000 Dec 31 Profit and Dec 31 Balance c/f 4,000 Dec 31 Rent 4,0

" 31 Accrued loss 20,000rent 4,000

20,000 20,000

The Journal

Date Details Dr Cr 2008Dec 31 Rent

Accrued rent

$4,000

$

4,000

(ii) Insurance Prepaid Insurance2008 $ 2008 $ 2008 $ 2008Dec 31 Bank 900 Dec 31 Profit and Dec 31 Insurance 265 Dec 31 Balance c/f 2

loss 635" 31 Prepaid

insurance 265900 900


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The Journal

Date Details Dr Cr 2008Dec 31 Prepaid insurance

Insurance

$265

$

265

(iii) Rates Prepaid Rates2008 $ 2008 $ 2008 $ 2008 $Jan 1 Bank 750 Dec 31 Profit and Dec 31 Rates 375 Dec 31 Balance c/f 375Jul 1 Bank 1,125 loss 1,500

" 31 Prepaidrates 375

1,875 1,875

The Journal

Date Details Dr Cr 2008Dec 31 Prepaid rates

Rates

$375

$

375

(iv) Rent Revenue Unearned Rent Revenue2008 $ 2008 $ 2008 $ 2008 $Dec 31 Profit and Apr 15 Bank 20,000 Dec 31 Balance c/f Dec 31 Rent revenue

loss 48,000 Dec 15 Bank 44,000 16,000 16,000" 31 Unearned rent

revenue 16,00064,000 64,000

The Journal

Date Details Dr Cr 2008Dec 31 Rent revenue

Unearned rent revenue

$16,000

$

16,000

4X (i) General Expenses Prepaid General Expenses2009 $ 2009 $ 2009 $ 2009 $Mar 31 Bank 6,150 Mar 31 Profit and Mar 31 General Mar 31 Balance c/f

loss 5,590 expenses 560 5" 31 Prepaid general

expenses 5606,150 6,150

The Journal

Date Details Dr Cr 2009Mar 31 Prepaid general expenses

General expenses

$560

$

560


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(ii) Commission Revenue Accrued Commission Revenue2009 $ 2009 $ 2009 $ 2009Mar 31 Profit and Mar 31 Bank 3,056 Mar 31 Commission Mar 31 Balance c/f

loss 3,231 " 31 Accrued revenue 175commissionrevenue 175

3,231 3,231

The Journal

Date Details Dr Cr 2009Mar 31 Accrued commission revenue

Commission revenue

$175

$

175

(iii) Carriage Outwards Accrued Carriage Outwards2009 $ 2009 $ 2009 $ 2009Mar 31 Bank 666 Mar 31 Profit and Mar 31 Balance c/f Mar 31 Carriage

" 31 Accrued carriage loss 788 122 outward

outwards 122788 788

The Journal

Date Details Dr Cr 2009Mar 31 Carriage outwards

Accrued carriage outwards

$122

$

122

(iv) Insurance Prepaid Insurance2008 $ 2009 $ 2009 $ 2009 Apr 1 Bank 1,080 Mar 31 Profit and Mar 31 Insurance 720 Mar 31 Balance c/f2009 loss 1,440Jan 1 Bank 1,080 " 31 Prepaid

insurance 7202,160 2,160

The Journal

Date Details Dr Cr 2009Mar 31 Prepaid insurance

Insurance

$720

$

720


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5 C ChanIncome Statement for the year ended 31 December 2008

$ $Sales 92,950Less Cost of goods sold:

Opening inventory 10,250

Add Purchases 55,85066,100Less Closing inventory (19,550) (46,550)

Gross profit 46,400Less Expenses:

Rent ($6,400 $1,600) 4,800Wages and salaries ($21,400 + $2,900) 24,300Insurance ($590 $190) 400Telephone ($300 + $110) 410General expenses 1,800 (31,710)

Net profit 14,690

6X K Chu

Income Statement for the year ended 31 March 2009$ $

Sales 108,380Less Returns inwards (2,000) 106,380Less Cost of goods sold:

Opening inventory 8,620Add Purchases 61,120

69,740Less Closing inventory (12,120) (57,620)

Gross profit 48,760Less Expenses:

Wages and salaries ($24,800 + $1,020) 25,820Motor expenses 2,120Rent and rates ($12,000 $800) 11,200Discounts allowed 290Lighting expenses ($580 + $170) 750Computer operating expenses ($1,210 $280) 930General expenses 3,600 (44,710)

Net profit 4,050

7 Happy WongIncome Statement for the year ended 31 December 2008

$ $Hairdressing revenue 100,400Less Expenses:

Advertising 2,300Car expenses ($4,800 ) 3,200

Rates ($1,400 $300) 1,100Telephone 1,100Sundry expenses 1,200Cleaning 150 (9,050)

Net profit 91,350

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Happy WongBalance Sheet as at 31 December 2008

$ $Non-current assets Shop premises 60,000Equipment 7,200

Car 26,40093,600Current assets Prepaid expenses 300Bank 5,400Cash 400

6,100Less Current liabilities

Accrued expenses (150)Net current assets 5,950

99,550

Financed by:Capital as at 1 January 2008 14,300Add Net profit for the year 91,35

105,650Less Drawings [$4,500 + ($4,800 )] (6,100

99,550

8X L TangIncome Statement for the year ended 31 December 2009

$ $ $Sales 120,320Less Returns inwards (1,384) 118,936Less Cost of goods sold:

Opening inventory 30,816Add Purchases 84,290

Less Returns outwards (810) 83,480

Add Carriage inwards 309114,605Less Closing inventory (36,420) (78,185)

Gross profit 40,751Add Other revenues:

Discounts received 506Rent revenue 2,500 3,006

43,757Less Expenses:

Discounts allowed 410Carriage outwards 218Motor expenses ($4,917 + $330) 5,247Repairs to premises 1,383Salaries and wages 16,184Sundry expenses ($807 + $162) 969Rates and insurance ($2,896 $332) 2,564Loan interest 4,000 (30,975)

Net profit 12,782

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9 (a) T LeeIncome Statement for the year ended 30 June 2009

$ $Fees charged 108,600Less Expenses:

Wages and salaries ($31,960 + $2,320) 34,280

Postage and stationery ($2,140 + $220) 2,360Telephone 1,250Computer operating expenses 2,190Travel expenses ($1,620 90%) 1,458Insurance ($890 $170) 720Rent ($23,000 $600) 22,400Sundry expenses 520 (65,178)

Net profit 43,422

T LeeBalance Sheet as at 30 June 2009

$ $Non-current assets Office furniture 10,800Equipment 25,400

36,200Current assets Accounts receivable 11,100Prepaid expenses ($600 + $170) 770Bank 8,090Cash 120

20,080Less Current liabilities

Accrued expenses ($220 + $2,320) (2,540)Net current assets 17,540

53,740Financed by:Capital as at 1 July 2008 19,680Add Net profit for the year 43,422

63,102Less Drawings [$9,200 + ($1,620 10%)] (9,362)

53,740

(b) No, both types of firms treat revenues and expenses in the same manner if they adopt accrual-basisaccounting. For trading firms, revenues are recognised when goods are sold. For service firms,revenues are recognised when services are provided. As for expenses, they are recognised by both types of firms when they are incurred.


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Application Problems

10XThe Journal

Date Details Dr Cr

2009 $ $Mar 31

" 31

" 31

" 31

BankRent revenue

Rent revenueProfit and loss ($340,000 + $24,000 $65,000 $38,000 + $42,000)

InsuranceBank

Profit and lossInsurance [$18,000 + ($12,000 ) ($18,000 )]

340,000

303,000

18,000

16,500

340,000

303,000

18,000

16,500

11X Salaries

2007 $ 2007Mar 31 Balance b/f 9,880 Mar 31 Profit and loss 12,18

" 31 Accrued c/f 2,30012,180 12,18

Electricity


" 31 Accrued c/f 6256,500 6,50

Rental Income

2007 $ 2007Mar 31 Profit and loss 150,000 Mar 31 Balance b/f 162,500" 31 Prepaid c/f 12,500

162,500 162,500

12 (a) One of the main differences between cash accounting and accrual accounting lies in the treatment of accruals and prepayments of revenues and expenses.Under cash accounting, revenues are recorded when cash is received and expenses are recorded

when cash is paid. This means that revenues are recognised when received and expenses arerecognised when paid.Under accrual accounting, a firm should only record revenues generated by goods sold or servicesrendered during a period and the expenses which have been incurred in generating those revenuesduring the same period, rather than the amounts actually received or paid during that period. Thismeans that revenues are recognised when earned and expenses are recognised when incurred.

(b) Cash accounting often leads to misleading results as a firm may have earned certain revenues duringa period but those revenues have not been recognised because they have not been received by theend of that period. Likewise, it may have incurred certain expenses during a period but thoseexpenses have not been recognised as they have not been paid by the end of that period. Owing toits inadequacy, cash accounting is not commonly used by businesses.

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13 (a) Jimmy ChanIncome Statement for the year ended 31 March 2010

$ $Sales 182,480Less Purchases (97,200)Gross profit 85,280

Less Expenses:Administrative expenses 42,570Selling and distribution expenses 21,230 (63,800)

Net profit 21,480

(b) Jimmy ChanIncome Statement for the year ended 31 March 2010

$ $Sales ($182,480 + $12,130) 194,610Less Cost of goods sold:

Purchases ($97,200 + $7,790) 104,990Less Closing inventory (14,700) (90,290)

Gross profit 104,320Add Interest revenue ($50,000 6% ) 1,00

105,320Less Expenses:

Administrative expenses ($42,570 + $6,000) 48,570Selling and distribution expenses [$21,230 ($2,400 )] 19,430 (68,000)

Net profit 37,320

(c) In (a), sales were recognised when cash was received. In (b), sales were recognised when sales were made, thus including trade receivables which arose dur ing the year.

In (a), purchases were recognised when cash was paid. In (b), purchases were recognised whengoods were obtained, thus including trade payables which arose during the year.

In (a), the gross profit was calculated by deducting purchases paid during the year from salesreceipts for the year. In (b), the gross profit was calculated by deducting the cost of goods soldfor the year from sales for the year. The cost of goods sold equalled the purchases made duringthe year less the value of unsold goods at the year end.

In (a), interest revenue was not recognised because it had not been received by the year end. In (b),interest revenue was recognised because it had been earned during the year.

In (a), expenses were recognised when paid. In (b), expenses were recognised when incurred,thus including the amounts accrued and deducting the amounts prepaid.

As a result, the net profits calculated in (a) and (b) were different.

14X (a) (i) Advertising and Promotions2008 $ 2008 $Jul 28 Bank 7,500 Apr 1 Accrued b/f 2,220Oct 15 Bank 12,600 2009

Mar 31 Profit and loss 14,400" 31 Prepaid c/f 3,480

20,100 20,100

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(ii) Printing and Stationery2008 $ 2009 Apr 1 Stationery b/f 20,400 Mar 31 Profit and loss 13,11Sept 14 Bank Stationery 5,100 " 31 Stationery c/f 18,602009Feb 12 Bank Printing 2,520

Mar 31 Accrued printing c/f 3,69031,710 31,71

(iii) Rental Income2009 $ 2008Mar 31 Profit and loss (12 months) 15,780 Apr 1 In advance b/f (3 months) 3,78

" 31 In advance c/f (3 months: $8,880 12) 4,440 Jul 1 Bank (6 months) 7,560Oct 1 Bank (6 months) 8,88

20,220 20,22

(iv) Rates2008 $ 2009 Apr 1 Prepaid b/f (3 months) 4,680 Mar 31 Profit and loss (12 months) 19,80Jul 1 Bank (6 months) 10,080 " 31 Prepaid c/f (3 months: $10,080 1

2) 5,040

Oct 1 Bank (6 months) 10,08024,840 24,84

(b) Financial ServicesBalance Sheet as at 31 March 2009 (extract)

Current assets $ Current liabilities $Stationery inventory 18,600 Accrued expenses 3,690Prepayments ($3,480 + $5,040) 8,520 Unearned revenues 4,440

Past Exam QuestionsPast Exam Questions

15 Insurance Account2006 $ 2006Mar 31 Balance b/f 8,100 Mar 31 Profit and loss 7,405

" 31 Prepayment c/f ($2,780 )8,100 8,10

Electricity Account


" 31 Accrual c/f 1,5608,040 8,04

Commission Income Account

2006 $ 2006Mar 31 Profit and loss 188,000 Mar 31 Balance b/f 200,000

" 31 Prepaid income c/f 12,000200,000 200,000

Rental Income Account

2006 $ 2006Mar 31 Profit and loss 140,000 Mar 31 Balance b/f 120,000

" 31 Accrued income c/f 20140,000 140,000

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FA! chapter 1