01 Accruals and Prepayments Test

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1 Chapter 1 Accruals and Prepayments Notes to teachers 1 Start with Chapter 4 of Frank Wood’s Introduction to Accounting and briefly explain to students how to record expenses and other revenues in the cash book and post entries to the general ledger. 2 Refer to Chapter 10 of Frank Wood’s Introduction to Accounting and briefly explain to students the accrual concept. 3 Explain the meaning of accrued expenses, prepaid expenses, accrued revenues and unearned revenues with the aid of real-life 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 assets’ and ‘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 said to be made on a cash basis. Students should know that the accrual concept is one of the fundamental principles underlying financial reporting. To correspond with the accrual concept, adjustments are required 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 year’s closing date. Q1 According to the accrual concept, a firm should only record revenues generated by goods sold or services rendered during a period, rather than the amounts actually received during that period. Similarly, a firm should only record expenses which have been incurred in generating those revenues during the same period, 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 when incurred. 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 been received by the end of that period. Notes to teachers

Transcript of 01 Accruals and Prepayments Test

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Chapter 1 Accruals and Prepayments

Notes to teachers

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

2 Refer to Chapter 10 of Frank Wood’s Introduction to Accounting and briefly explain to students the accrual concept.

3 Explain the meaning of accrued expenses, prepaid expenses, accrued revenues and unearned revenues with the aid of real-life 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 assets’ and ‘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 said to be made on a cash basis. Students should know that the accrual concept is one of the fundamental principles underlying financial reporting. To correspond with the accrual concept, adjustments are required 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 year’s closing date.

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

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 been received by the end of that period.

Notes to teachers

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

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

Q6 Accrued revenues are assets of the firm and therefore the accrued revenue account should be classified as a 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 be understated.

A5 This is because prepaid expenses represent goods or services that are expected to be consumed within one 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 its customers 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 Hui Income 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 $ 2009 $Feb 26 Bank 1,800 Dec 31 Profit and loss 3,000Aug 24 Bank 1,800 " 31 Prepaid insurance 600 3,600 3,600

2010 Jan 1 Prepaid insurance 600

Prepaid Insurance

2009 $ 2009 $Dec 31 Insurance 600 Dec 31 Balance c/f 600

2010 2010 Jan 1 Balance b/f 600 Jan 1 Insurance 600

Rent Revenue

2009 $ 2009 $Dec 31 Profit and loss 30,000 Sept 24 Bank 10,000 " 31 Unearned rent revenue 10,000 Oct 25 Bank 10,000 Nov 26 Bank 10,000 Dec 28 Bank 10,000 40,000 40,000

2010 Jan 1 Unearned rent revenue 10,000

Unearned Rent Revenue

2009 $ 2009 $Dec 31 Balance c/f 10,000 Dec 31 Rent revenue 10,000

2010 2010 Jan 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 Wood’s 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 not appear in current assets.

• The items ‘accounts payable’, ‘accrued expenses’ and ‘unearned revenues’ would not appear in current liabilities.

A13 Accrual accounting can more accurately measure the financial performance (i.e., profitability and liquidity) 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 as revenues while the amounts received but not yet earned would not be excluded and not treated as revenues.

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 recorded as expenses while the amounts paid but not yet incurred would not be excluded and not treated as expenses 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.

ASSESSMENT

Short QuestionsShort Questions

1 (i) Rent

2008 $ 2008 $Dec 31 Bank 16,000 Dec 31 Profit and loss 20,000 " 31 Accrued c/f 4,000 20,000 20,000

(ii) Insurance

2008 $ 2008 $Dec 31 Bank 900 Dec 31 Profit and loss 635 " 31 Prepaid c/f 265 900 900

(iii) Rates

2008 $ 2008 $Jan 1 Bank 750 Dec 31 Profit and loss 1,500Jul 1 Bank 1,125 " 31 Prepaid c/f ($1,125 × ) 375 1,875 1,875

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(iv) Rent Revenue

2008 $ 2008 $Dec 31 Profit and loss ($4,000 × 12) 48,000 Apr 15 Bank 20,000 " 31 In advance c/f 16,000 Dec 15 Bank 44,000 64,000 64,000

2X (i) General Expenses

2009 $ 2009 $Mar 31 Bank 6,150 Mar 31 Profit and loss 5,590 " 31 Prepaid c/f 560 6,150 6,150

(ii) Commission Revenue

2009 $ 2009 $Mar 31 Profit and loss 3,231 Mar 31 Bank 3,056 " 31 Accrued c/f 175 3,231 3,231

(iii) Carriage Outwards

2009 $ 2009 $Mar 31 Bank 666 Mar 31 Profit and loss 788 " 31 Accrued c/f 122 788 788

(iv) Insurance

2008 $ 2009 $Apr 1 Bank 1,080 Mar 31 Profit and loss 1,4402009 " 31 Prepaid c/f ($1,080 × 69) 720Jan 1 Bank 1,080 2,160 2,160

3 (i) Rent Accrued Rent

2008 $ 2008 $ 2008 $ 2008 $Dec 31 Bank 16,000 Dec 31 Profit and Dec 31 Balance c/f 4,000 Dec 31 Rent 4,000 " 31 Accrued loss 20,000 rent 4,000 20,000 20,000

The Journal

Date Details Dr Cr

2008Dec 31 Rent

Accrued rent

$4,000

$

4,000

(ii) Insurance Prepaid Insurance

2008 $ 2008 $ 2008 $ 2008 $Dec 31 Bank 900 Dec 31 Profit and Dec 31 Insurance 265 Dec 31 Balance c/f 265 loss 635 " 31 Prepaid insurance 265 900 900

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The Journal

Date Details Dr Cr

2008Dec 31 Prepaid insurance

Insurance

$265

$

265

(iii) Rates Prepaid Rates

2008 $ 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 Prepaid rates 375 1,875 1,875

The Journal

Date Details Dr Cr

2008Dec 31 Prepaid rates

Rates

$375

$

375

(iv) Rent Revenue Unearned Rent Revenue

2008 $ 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 16,000 64,000 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 Expenses

2009 $ 2009 $ 2009 $ 2009 $Mar 31 Bank 6,150 Mar 31 Profit and Mar 31 General Mar 31 Balance c/f loss 5,590 expenses 560 560 " 31 Prepaid general expenses 560 6,150 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 Revenue

2009 $ 2009 $ 2009 $ 2009 $Mar 31 Profit and Mar 31 Bank 3,056 Mar 31 Commission Mar 31 Balance c/f loss 3,231 " 31 Accrued revenue 175 175 commission revenue 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 Outwards

2009 $ 2009 $ 2009 $ 2009 $Mar 31 Bank 666 Mar 31 Profit and Mar 31 Balance c/f Mar 31 Carriage " 31 Accrued carriage loss 788 122 outwards 122 outwards 122 788 788

The Journal

Date Details Dr Cr

2009Mar 31 Carriage outwards

Accrued carriage outwards

$122

$

122

(iv) Insurance Prepaid Insurance

2008 $ 2009 $ 2009 $ 2009 $Apr 1 Bank 1,080 Mar 31 Profit and Mar 31 Insurance 720 Mar 31 Balance c/f 7202009 loss 1,440 Jan 1 Bank 1,080 " 31 Prepaid insurance 720 2,160 2,160

The Journal

Date Details Dr Cr

2009Mar 31 Prepaid insurance

Insurance

$720

$

720

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5 C Chan Income Statement for the year ended 31 December 2008

$ $Sales 92,950Less Cost of goods sold: Opening inventory 10,250 Add Purchases 55,850 66,100 Less Closing inventory (19,550) (46,550)Gross profit 46,400Less Expenses: Rent ($6,400 – $1,600) 4,800 Wages and salaries ($21,400 + $2,900) 24,300 Insurance ($590 – $190) 400 Telephone ($300 + $110) 410 General 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 8,620 Add Purchases 61,120 69,740 Less Closing inventory (12,120) (57,620)Gross profit 48,760Less Expenses: Wages and salaries ($24,800 + $1,020) 25,820 Motor expenses 2,120 Rent and rates ($12,000 – $800) 11,200 Discounts allowed 290 Lighting expenses ($580 + $170) 750 Computer operating expenses ($1,210 – $280) 930 General expenses 3,600 (44,710)Net profit 4,050

7 Happy Wong Income Statement for the year ended 31 December 2008

$ $Hairdressing revenue 100,400Less Expenses: Advertising 2,300 Car expenses ($4,800 × ) 3,200 Rates ($1,400 – $300) 1,100 Telephone 1,100 Sundry expenses 1,200 Cleaning 150 (9,050)Net profit 91,350

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Happy Wong Balance Sheet as at 31 December 2008

$ $Non-current assetsShop premises 60,000Equipment 7,200Car 26,400 93,600Current assetsPrepaid 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 91,350 105,650Less Drawings [$4,500 + ($4,800 × )] (6,100) 99,550

8X L Tang Income Statement for the year ended 31 December 2009

$ $ $Sales 120,320Less Returns inwards (1,384) 118,936Less Cost of goods sold: Opening inventory 30,816 Add Purchases 84,290 Less Returns outwards (810) 83,480 Add Carriage inwards 309 114,605 Less Closing inventory (36,420) (78,185)Gross profit 40,751Add Other revenues: Discounts received 506 Rent revenue 2,500 3,006 43,757Less Expenses: Discounts allowed 410 Carriage outwards 218 Motor expenses ($4,917 + $330) 5,247 Repairs to premises 1,383 Salaries and wages 16,184 Sundry expenses ($807 + $162) 969 Rates and insurance ($2,896 – $332) 2,564 Loan interest 4,000 (30,975)Net profit 12,782

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9 (a) T Lee Income 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) 2,360 Telephone 1,250 Computer operating expenses 2,190 Travel expenses ($1,620 × 90%) 1,458 Insurance ($890 – $170) 720 Rent ($23,000 – $600) 22,400 Sundry expenses 520 (65,178)Net profit 43,422

T Lee Balance Sheet as at 30 June 2009

$ $Non-current assetsOffice furniture 10,800Equipment 25,400 36,200Current assetsAccounts 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-basis accounting. 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

Bank Rent revenue

Rent revenue Profit and loss ($340,000 + $24,000 – $65,000 – $38,000 + $42,000)

Insurance Bank

Profit and loss Insurance [$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 $ 2007 $Mar 31 Balance b/f 9,880 Mar 31 Profit and loss 12,180 " 31 Accrued c/f 2,300 12,180 12,180

Electricity

2007 $ 2007 $Mar 31 Balance b/f 5,875 Mar 31 Profit and loss 6,500 " 31 Accrued c/f 625 6,500 6,500

Rental Income

2007 $ 2007 $Mar 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 are recognised when paid.

Under accrual accounting, a firm should only record revenues generated by goods sold or services rendered during a period and the expenses which have been incurred in generating those revenues during the same period, rather than the amounts actually received or paid during that period. This means 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 during a period but those revenues have not been recognised because they have not been received by the end of that period. Likewise, it may have incurred certain expenses during a period but those expenses have not been recognised as they have not been paid by the end of that period. Owing to its inadequacy, cash accounting is not commonly used by businesses.

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

$ $Sales 182,480Less Purchases (97,200)Gross profit 85,280Less Expenses: Administrative expenses 42,570 Selling and distribution expenses 21,230 (63,800)Net profit 21,480

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

$ $Sales ($182,480 + $12,130) 194,610Less Cost of goods sold: Purchases ($97,200 + $7,790) 104,990 Less Closing inventory (14,700) (90,290)Gross profit 104,320Add Interest revenue ($50,000 × 6% × ) 1,000 105,320 Less Expenses: Administrative expenses ($42,570 + $6,000) 48,570 Selling 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 during the year.

• In (a), purchases were recognised when cash was paid. In (b), purchases were recognised when goods 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 sales receipts for the year. In (b), the gross profit was calculated by deducting the cost of goods sold for the year from sales for the year. The cost of goods sold equalled the purchases made during the 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 Promotions

2008 $ 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 Stationery

2008 $ 2009 $Apr 1 Stationery b/f 20,400 Mar 31 Profit and loss 13,110Sept 14 Bank — Stationery 5,100 " 31 Stationery c/f 18,6002009Feb 12 Bank — Printing 2,520Mar 31 Accrued printing c/f 3,690 31,710 31,710

(iii) Rental Income

2009 $ 2008 $Mar 31 Profit and loss (12 months) 15,780 Apr 1 In advance b/f (3 months) 3,780 " 31 In advance c/f (3 months: $8,880 × 12) 4,440 Jul 1 Bank (6 months) 7,560 Oct 1 Bank (6 months) 8,880 20,220 20,220

(iv) Rates

2008 $ 2009 $Apr 1 Prepaid b/f (3 months) 4,680 Mar 31 Profit and loss (12 months) 19,800Jul 1 Bank (6 months) 10,080 " 31 Prepaid c/f (3 months: $10,080 × 12) 5,040Oct 1 Bank (6 months) 10,080 24,840 24,840

(b) Financial Services Balance 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 Account

2006 $ 2006 $Mar 31 Balance b/f 8,100 Mar 31 Profit and loss 7,405 " 31 Prepayment c/f ($2,780 × ) 695 8,100 8,100

Electricity Account

2006 $ 2006 $Mar 31 Balance b/f 6,480 Mar 31 Profit and loss 8,040 " 31 Accrual c/f 1,560 8,040 8,040

Commission Income Account

2006 $ 2006 $Mar 31 Profit and loss 188,000 Mar 31 Balance b/f 200,000 " 31 Prepaid income c/f 12,000 200,000 200,000

Rental Income Account

2006 $ 2006 $Mar 31 Profit and loss 140,000 Mar 31 Balance b/f 120,000 " 31 Accrued income c/f 20,000 140,000 140,000

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