Accruals and prepayments

Accruals and prepayments – the bane of an AAT student’s Level 3 life!.

In this post, I’m going to try and explain accruals and prepayments in a way that will (hopefully) help you to understand them.

Before we even try to tackle a prepayment or accrual, it’s important to remind ourselves about the effect of a transaction on a t-account:

Prepayment of expenses

Imagine you have a 13 litre bucket full of water (Bucket 0X1) and an empty 13 litre bucket (Bucket 20X2) (stay with me here).

20X1		20X2

  

You move 1 litre water from bucket 20X1 to Bucket 20X2. You now have one bucket with 12 litres in (20X1) and one with 1 litre (20X2).

20X1		20X2

Now, instead of buckets and water, we have expense accounts and amounts – can you see where I’m going with this? The water represents monetary amounts – the buckets represent accounts. Here, we’re saying that £1 is being moved from 20X1 to 20X2 as it ‘belongs there’ as the expense relates to an expense that will be incurred during 20X2 (e.g. advance payment of rent). We’ll take £1 from 20X1 and move it to 20X2 by using double entry bookkeeping so that we correctly show the amount of expenditure that applies to 20X1 and the £1 is already registering as a prepaid expense (albeit prepaid) in 20X2. The balancing figure for this t-account of £12 is the expense for the year.

Expense Account
31/12/20X1	Bank	13	31/12/20X1	Prepayment c/d	1
			31/12/20X1	Statement of profit or loss (SPL)	12
		13			13

The prepayment is held in a prepayment account until the start of the new year when we transfer it to the expense account for 20X2:

Prepayment
31/12/20X1	Prepaid expense b/d	1	1/1/20X2	Expense	1
		1			1

Expense Account
1/1/20X2	Prepayment	1

This £1 will be included in 20X2’s expenses plus any further expense incurred during the year.

Let’s now look at accrued expenses (accruals)

Again, we use the bucket analogy:

		1 litre belongs in 20X1
20X1		20X2

Here we’ll top up 20X1’s bucket with the yellow 1 litre:

20X1		20X2

Now we can see that 20X1 is full and that 20X2 has reduced in volume by 1 litre.

Again, we can take this analogy and turn it into an accounting question:

Expense Account
31/12/20X1	Bank	12	31/12/20X1	SPL	13
31/12/20X1	Accrued expense c/d	1
		13			13

As with prepayments, the accrual is reversed at the start of the new year:

Accrued expense
1/1/20X2	Expense	1	1/1/20X2	Accrued expense b/d	1
		1			1

Expense Account
			1/1/20X2	Accrued expense	1

It’s common to have to deal with accruals as you will receive invoices relating to events, purchases and services used after the year end. You will allocate part of the invoice to the previous year (20X1) with the remainder relating to the current year 20X2.

Prepaid and accrued Income can be dealt with in a very similar manner – making sure that you remember that incomes naturally exist on the credit side of the t-account so, to increase the value of the t-account (an accrued expense) you credit it and debit the accrued income and to decrease the income account (prepaid income) you debit the income account and credit the prepaid income account.

IMPORTANT

You need to understand that the accruals and prepayments are carried between years (as we saw above) via the statement of financial position (or as old people call it – the balance sheet).

Prepaid expenses	Debit	Current asset (as we’re owed the money as we paid upfront and so could ask for a refund)
Accrued expenses	Credit	Current liability (a s we owe the amount at year end – we’re liable to pay it)
Prepaid income	Credit	Current liability (we could be asked to repay the customer if we fail to deliver)
Accrued income	Debit	Current asset

In my experience, the thing people have most difficulty with is deciding what part of the expense/income relates to the year we’re dealing with and what part relates to next year/last year. Obviously, we’re likely to encounter situations when the expense or income relates to parts of two accounting periods.

The best way to deal with these is to use a timeline approach.

Example

You have been working on a business’ accounts for the year ended 31 December 2013. You may ignore VAT for this task.

You have the following information:

Balances at:	1 January 2013
Accrual for rent paid	£800
Prepayment for motor expenses	£600

The bank summary for the year shows payments for rent of £11,250. Included in this figure is £1,800 for the quarter ended 28 February 2014

a)      You are to write up the Rent paid account for the year ended 31 December 2013 and close it off by showing the transfer to the statement of profit or loss. (You do not need to show dates)

Rent paid
Bank	11,250	Accrual b/d	800
		SPL	9,250
		Prepayment c/d	1,200
	11,250		11,250

The bank summary for the year shows payments for motor expenses of £15,700. In January 2014, £250 was paid for administration expenses incurred in December 2013.

b)      You are to prepare the administration expenses account for the year ended December and close it off by showing the transfer to the income statement. Include dates.

Motor expenses
1/1/13	Prepayment b/d	600	31/12/13	SPL	16,550
31/12/13	Bank	15,700
31/12/13	Accrual   c/d	250
		16,550			16,550

So, let’s see how we can solve this question with a time line approach.

In part (a) we’re told that some of the expense we’ve paid during the year (£1,800) relates to the quarter ended 28^th February 2014. 

A ‘quarter’ is 3 months so, we can now assign a monthly figure for this expense (we assume that expenses/incomes occur evenly over time):

£1,800 ÷ 3 = £60 per month.

Our year end is 31 December 2013.

Now, let’s put all of this onto a timeline:

£1,800 for the period 1 December 2013 – 28 February 2014
£600	£600	£600
December 2013	January 2014	February 2014
Year end

Using this approach makes it much easier to see that only part of the £1,800 ‘belongs’ on 2013, with the remainder belonging in 2014.

We must also ensure that we’re very clear on when this expense was actually paid - here we’re told that it’s included in the expenses account at the end of 2013 and so it must be a prepayment. So, we have £1,200 prepaid and can now carry out the t-accounting: Debit Prepayment, Credit Expense

Part (b) – here we can adopt a similar procedure:

Belongs here	£250 (paid here)
December 2013	January 2014	February 2014
Year end

Again, the expense must be moved – but this time, backwards into 2013. As we’ve not yet paid it, it must be an accrual so we can now Debit Expense (2013) £250 and Credit Accrued expense £250.

It’s common to see a similar situation as with part (a) where an accrual relates to two financial years – adopting the timeline approach will help you tackle the question confidently.

In summary, then, we need a standard approach to any accrual/prepayment question so, why not try this:

1)      Establish the position at the start of the financial reporting period (i.e. the beginning of the year we’re dealing with)

2)      Identify the bank transactions for each income or expense.

3)      Establish the position at the end of the reporting period – do we have any prepayments or accruals of expenses of incomes.

4)      Balance off the t-account to calculate the expense/income figure for the reporting period you’re dealing with (The SPL figure).

Hopefully, these rambling will help you get to grips with accruals and prepayments – please leave a comment if you find any errors or would like to request a subject for a Level 3 blog post.

Good luck

FSTP (Preparing final accounts for sole traders and partnerships) - Assessment tips

FSTP (Preparing final accounts for sole traders and  partnerships)

FSTP - the second financial accounting unit at Level 3 - often appears to be quite a straightforward and small unit at first glance. Indeed, I often see people saying that the books are small compared to ACPR. Don't be fooled by the short books! This unit holds a lot of nasty twists if you're not fully confident/competent with material covered in ACPR and, more importantly, Level 2 financial accounting units PBKT & CJBS.

Let's take a look at the assessment task by task and try to identify common errors.

Incomplete records

Task 1 is all about incomplete records.

It always pays dividends to take a little time to read and re-read the information provided for this task as, in my experience, it's very common for students to skim the written information in favour of jumping in a completing each element of the task.

It is very common to have to complete either the Sales ledger control account (SLCA) or Purchase ledger control account (PLCA) and, to be honest, given the typical information you're provided, I would expect any Level 2 student to be able to competently draw up the SLCA or PLCA. Between Level 2 and Level 3, nothing changes with regards to the items one would expect to find in these accounts. It's also important to remember where you get the information from (i.e. day books) as, again, this should be very familiar territory for all competent Level 2's.

Remember that gross (inclusive of VAT) figures are used to help complete the SLCA and PLCA whilst discounts allowed and received should not be forgotten. You should also remember to check any information about bad debt write offs, returned cheques and  contra entries as these will all affect the closing balance *(which is sometimes the figure you're asked to find). 

Sometimes you have to find the closing balance, whilst other times you have to complete the t-account (including opening and closing balances which have been given)  in order to be able to establish the missing figure (which, of course, you will be told needs to be calculated).

Sometimes you are also asked to complete a VAT control account which, as with SLCA and PLCA, should not be to much of a problem - epsecially given that you are usually given nearly all the figures you need to complete the task. Remember input VAT (on expenses identified in the informtion, sales returns and purchases) are debits and outputs (on sales and purchase returns) - often this information will also be found in the extracts of the day books (Sales day book, Purchases day book etc). It is very common to have to calculate the payment made to HMRC (a debit in VAT account) and this should be entered as the balancing figure.

Sometimes you will have to reconstruct a bank t-account and, again, the majority of the information if already given to you - just remember that money in is a debit and money out is a credit.

Task 1 is not a difficult task - if you're well prepared and, of course, you take time to RTFQ (Read The Full Question)!

Task 2 often requires you to find a missing figure by employing the accounting equation:

Assets - Liabilities = Capital

Make sure that you can also identify assets, liabilities and capital items (Capital, Drawings and Profit/Loss) as, without this, you will not succeed in this task.

Task 2 also requires you to employ the margin/mark-up techniques in order to calculate missing elements of a Trading account. See my blog entry on Mark-up and Margin for guidance on a fool-proof way to be able to answer any task thrown at you.

Task 2 often has a few tick box/multiple choice tasks - take care to RTFQ here too as it's very common to miss key words/phrases and, therefore, give an incorrect answer.

For example, one practice task I've seen asks you to identify where one would find a prepayment of income in the financial statements. It's so common for students to select current asset because, of course, they know that prepayments are assets. Sadly, however, missing the key word income in prepayment of income means they get 0 marks as a prepaid income is a current liability (think about it - we may have to pay it back!)

Task 3 is often very well done as students love the financial statements - just remember to check to see if you're allowed to use a minus symbol for negative figures as, of course, -£100 is very different from £100 and the computer won't know what you 'meant' when you entered your figure.

Task 3 also often has tasks similar to ACPR which check your general accounting knowledge so, if you had a few difficulties in ACPR with these multiple choice tasks, revise the same sort of material for this part of FSTP too.

Partnership Accounting

Task 4 deals with partnership accounting and you're often required to complete a t-account to show the introduction and elimination of goodwill. Remember, in the Goodwill account, the goodwill is created by debiting the a/c in the old profit share ratio and elimination is achieved by crediting it in the new profit share ratio (in with the old, out with the new may help here).

Take care to complete the correct things too - sometimes, students make all the entries one would expect to see in the capital accounts but, sadly, they make them in the goodwill account and, therefore, they are all on the wrong side of the t-account. Similarly, it's very common for students to make all the entries for an admission of a new partner but, they have actually been asked to deal with a retirement of a partner. Therefore, 4 little letters come out to play again RTFQ!

You will also be required to complete either an appropriation account or the current accounts for a partnership. Again, please take a few minutes to RTFQ (twice even) to be sure you're fully aware what you've been asked to do - it's so common to see students making all the entries in an appropriation account in both time periods when, in fact one of the partners has not been a partner for part of the year. Partners are only entitled to salaries, interest on capital and have to pay interest on drawings only when they are actually partners. Partners do not receive salaries or interest on capital before they join the partnership and, similarly, they do not pay interest on drawings before they join Partners are also only entitled to a share of the profits earned when they were actually a partner, so, if a partner leaves six months into the year, he/she should only receive a share of the profits earned whilst he/she was a partner. (I may appear to have over-emphasised this but I know from experience how many people do forget - almost as if they're on autopilot).

You should also remember that you may be completing a partnership appropriation account for a year (12 months). It is so common to find students miscounting the number of months for each profit share ratio. For example, let's look at situation where the accounting year is April to March and a partner leaves at the end of October. The partner leaving has been a partner for how many months - I see some of you counting on fingers now whilst other jump straight in with 6 months. Sadly those who jump in are incorrect:

April May June July August September October (when the partner leaves) = 7 months not 6!

Take a moment to learn to check your 'gut feeling' by counting properly!

Finally, you have to complete a statement of financial position (SFP) for a partnership - again, most students do this really well. Just take a minute to remember that you may have to take the current account calculated in part a of this task and include it in the Financed by section at the bottom of the statement - don't be tempted to use the figures included in trial balance (you're told to use the figures calculated in part a instead of the figures in the trial balance, so there really is no excuse for getting this wrong.

One important point to remember with the SFP is the order of liquidity in the current assets. This is the order you list the current assets:

• Inventory
• Trade receivables (less any allowance for doubtful debt)
• Prepayments
• Bank (not overdrafts which are current liabilities)
• Cash

Similarly, there is a preferred order for current liabilities:

• Trade payables
• VAT
• Bank overdraft

This is not a difficult assessment to pass just make sure that you're well prepared. Things to remember are:

• RTFQ
• Revise what goes where in SLCA/PLCA/BANK/CASH and VAT accounts
• Be happy classifying accounts as assets, liabilities, capital, expenses or incomes.
• Make sure that you can also understand the effect of a debit/credit entry on each type fo account (e.g. a credit reduces the value of an expense account).
• Partnerships - be very clear what you've been asked to do and what information is available to you. Make sure that you account the correct event (partner joining or leaving the partnership) and, of course, make sure you know when the profit share ratio changes.

You have 2 hours for this assessment but, in reality, you can be out of there much quick if you're well prepared.

Final advice comes in 4 parts:

RTFQ
Practice
Practice
Practice

Good luck!