Financial Accounting

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3 3 Section D: Recording Transactions and Events Designed to give you knowledge and application of: D1. Sales and purchases D3. Inventory D4. Tangible non-current assets D5. Depreciation D7. Accruals & payments D8. Receivables & payments D9. Provisions & contingencies

4 4 Study Guide D7: Accruals and Prepayments:  Understand how the matching concept applies to accruals and prepayments. [1]  Identify and calculate the adjustments needed for accruals and prepayments in preparing financial statements. [1]  Illustrate the process of adjusting for accruals and prepayments in preparing financial statements. [1]  Prepare journal entries and ledger entries for the creation of an accrual or prepayment. [1]  Understand and identify the impact on profit and net assets of accruals and prepayments. [1] Learning outcomes

5 5 What is a matching concept? According to the accrual concept, the effect of transactions and other events are recognised when they occur and they are recorded in the accounting records and reported in the financial statements of the period to which they relate. Expenses are recognised in the SOCI (Income statement) on the basis of direct association between cost incurred and earning of specific items of income. This process is known as matching of costs with revenue. It involves simultaneous or combined recognition of revenue and expenses that result directly and jointly from the same transaction or event. Matching of cost and earning of specific item What is an accrual concept? Refer to Examples on pages 276 and 277

6 6 Accrued expenses Journal Entry Dr Interest on loan (Expense)$22,500 Cr Provision for interest accrued on term loan (Liability) $22,500 Being interest accrued on loan recorded $$ Provision for accrued interest 22,500SOCI (Transfer)22,500 A proforma of expense account Interest expense account Year 20X6/20X7 A proforma of liability account $$ Balance c/f22,500Interest expense22,500 Accrued Interest Liability account Year 20X6/20X7

7 7 Prepaid Expenses Meaning Some expenses are paid for in advance. The accountant has to ensure that, of the total expenses, the part which relates to the current financial year is presented as an expense and the part which relates to the next financial year is carried forward as an asset – ‘prepaid expenses’. 7

8 8 Example PQR Ltd obtains an insurance policy for fire and similar risks for the year from 1 November 20X6 by paying a premium of $24,000 for full year in advance. The reporting date is 31 December 20X6. Current year - $24,000/12 x 2 months = $4,000 Next Year - $24,000/12 x 10 months = $20,000 (prepaid for the period January 20X7 to October 20X7) Prepaid Expenses Total amount paid on 1 November 20X6 for 12 months i.e. from 1 November 20X6 to 31 October 20X7 is $24,000 FY 20X6 FY 20X7 Date of payment Reporting date Paid up to this date 1 Nov 20X631 Dec 20X631 Oct 20X7 2 months $4, months $20,000 EXPENSES SOCI (IS) PREPAID EXPENSES SOFP

9 9 Accrued Income Example Mozart rented out it’s business premises for rent of $400 per month from April 20X6.The rent for the period Jan 20X7 to March 20X7 is yet to be received. The reporting date is 31 March. Rent for April 20X6 – December 20X6, received $3,600 (9 Months) Rent for January 20X7 – March 20X7, not received $1,200 (3 months) The tenant had used the premises. Rent for the 3 months from January to March 20X7 had accrued even though it had not been actually received. Mozart therefore needs to record an amount of $1,200 ($400 x 3) in his accounts as rent receivable Total amount accrued from April 20X6 to March 20X7 is $4,800. $4,800 Reflected as income in (SOCI) IS Year 20X6Year 20X7 Date for premises given on rent Paid up to this date Reporting date 1 Apr 20X6 31 Dec 20X6 31 Mar 20X7 9 months $3,600 3 months $1,200 Received income Accrued income

10 Income received in advance Meaning: income is occasionally received before it accrues – it is sometimes received in advance Example A firm of lawyers received $10,000 as their fees for a case. The amount included 2 hearings. On the SOFP date i.e. March 20X7, only one hearing took place; the other hearing was on April 20X7. But the amount for both the hearings was received. Since only half of the work was complete, only half of the fees had accrued. However, the full amount was already received.  Half of the fees i.e. $10,000 x ½ = $5,000 are treated as revenue in 20X7  The remaining amount is treated as income received in advance

11 Income received in advance Presentation in the financial statements The income from professional fees in the SOCI (income statement) is reduced by $5,000. The fees received in advance are shown as a current liability in the SOFP. Impact on profit and net assets  If income is reduced by $5,000, the current profits also reduce by $5,000.  If a new liability is recorded, the net assets reduce by $5,000. At the beginning of the next year, the journal entry is reversed Dr Professional fees received in advance (SOFP)5,000 Cr Professional fees (SOCI) 5,000 Being the entry to transfer rent receivable to rent income account, i.e. the reversal of last year’s entry 11

12 RECAP  Understand how matching concept applies to accruals and prepayments?  Identify and calculate the adjustments needed for accruals and prepayments in preparing financial statements?  Process of adjusting for accruals and prepayments  Prepare Journal and Ledger entries for creation of an accrual or prepayment?  Identify impact of profit on net assets of accruals and prepayments? 12