CIMA - C2 Fundamentals of Financial Accounting
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110 7: Preparing accounts: concepts and conventions ⏐ Part B Accounting systems and accounts preparation
A system of accounting based principally on replacement costs, and measuring profit as the increase in physical capital,
was used in the UK for some years (called current cost accounting).
The main accounting system has always been, and will continue to be, historical cost accounting. However, current cost
accounting was developed as a possible solution to certain problems which arise in periods of rising prices. Theoretical
and practical problems in the current cost accounting system led to its withdrawal in the UK.
Attempts to solve the problems of inflation have a long history in the UK and abroad. One step common in practice is to
prepare modified historical cost accounts. This means that up-to-date valuations are included in the historical cost
statement of financial position for some or all of a company's non-current assets, without any other adjustments being
made. No attempt is made to tackle the difficulties of profit measurement.
For the foreseeable future, historical cost accounting is likely to be the most important system in the UK, despite its
inability to reflect the effects of inflation.
There are a number of reasons why this is so.
(a) It is easy and cheap. Other methods tend to be far more complicated and onerous to use, particularly for small
businesses. Also, there is no agreement on an alternative.
(b) The fact that non-current asset revaluation is permitted or encouraged means that there is less likelihood of a
serious understatement of actual value distorting the statement of financial position valuation of the business.
(c) It is easy to understand and users are aware of its limitations, so make appropriate allowances. Alternative
methods generally involve much more complex concepts.
(d) The figures are easy to obtain and are objective and readily verifiable, being tied to actual transactions. Other
methods depend more on subjective valuations.
It is important to note that, legally, a business does not have to account for inflation.
Question
Inflation
In a period when prices are rising, the profit shown under the historical cost convention will differ from that shown under
the current cost convention. In the case of a retail trading company, which of the two profit figures will be higher?
Answer
The profit shown under the historical cost convention will be higher. This is because the value of the resources used is
their cost at the time they were purchased. Under the current cost convention, the value of these resources is their cost
at the (later) time when they were replaced. Given that prices are rising, this cost will be higher and so reported profits
will be less.
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Part B Accounting systems and accounts preparation ⏐ 7: Preparing accounts: concepts and conventions 111
Chapter roundup
• IAS 1 describes going concern, accruals and consistency as fundamental assumptions of accounting.
• IAS 1 also considers three other concepts extremely important. Prudence, substance over form and materiality should
govern the selection and application of accounting policies.
• A basic principle of accounting is that resources are normally stated in accounts at historical cost, ie at the amount
which the business paid to acquire them.
Quick quiz
1 The eight accounting concepts or principles are:
(1) _______________________ (5) _______________________
(2) _______________________ (6) _______________________
(3) _______________________ (7) _______________________
(4) _______________________ (8) _______________________
2 Fill in the blanks.
(a) The entity concept means that a business is treated as a ___________________________
______________________________, distinct from its __________________________ or
__________________________ .
(b) The money measurement concept means that accounts deal only with items _________________
_____________________________________________________________________________.
(c) The going concern concept implies that a business _____________________________________
____________________________________________________________________________.
(d) The prudence concept means that in situations of uncertainty, ____________________________
____________________________________________________________________________.
(e) The accruals concept means that in computing profit, _______________________________
___________________________________________________________________________.
(f) The consistency concept means that similar items in a set of accounts ______________________
___________________________________________________________________________ and that the same
treatment should be applied ___________________________________________
____________________________________________________________________________.
(g) Substance over form means that transactions are disclosed in accordance with
________________________________________________________________.
(h) The materiality concept states that a matter is material if its _______________________________
_________________________________________________________________________________________
__________________________________________________________________.
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112 7: Preparing accounts: concepts and conventions ⏐ Part B Accounting systems and accounts preparation
3 At what stage is it normal to recognise the revenue arising from a credit sale?
A When the goods are dispatched
B When the goods are delivered and accepted
C When the invoice is raised
D When payment is received
4 Are these statements true or false?
(a) If the accruals concept and the prudence concept conflict, prudence prevails.
(b) If the consistency concept and the prudence concept conflict, prudence prevails.
5 Six possible values that might be attributed to a piece of machinery in a statement of financial position are:
(1) _______________________ (4) _______________________
(2) _______________________ (5) _______________________
(3) _______________________ (6) _______________________
6 Financial capital maintenance means?
A The business has the same quantity of assets at the end of the year as it had at the start
B The business has made a profit in the year
C The business proprietor has withdrawn only sufficient profits so that the business is able to replace its stock
D The original financial capital of the business is the same at the end of the year as it was at the start allowing for
profit and drawings
Answers to quick quiz
1 (1) Entity
(2) Money measurement
(3) Going concern
(4) Prudence
(5) Accruals
(6) Consistency
(7) Substance over form
(8) Materiality
2 (a) The entity concept means that a business is treated as a separate entity, distinct from its owners or managers.
(b) The money measurement concept means that accounts deal only with items to which a monetary value can be
attributed.
(c) The going concern concept implies that a business will continue in operation for the foreseeable future.
(d) The prudence concept means that where there is uncertainty, appropriate caution is exercised when
recognising transactions.
(e) The accruals concept means that in computing profits amounts are included in accounts in the period they are
earned or incurred, not received or paid.
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Part B Accounting systems and accounts preparation ⏐ 7: Preparing accounts: concepts and conventions 113
(f) The consistency concept means that similar items in a set of accounts should be given similar accounting
treatment and that the same treatment should be applied from one period to another in accounting for similar
items.
(g) Substance over form means that transactions are disclosed in with the commercial reality, not the letter of the
law.
(h) The materiality concept states that a matter is material if its omission or misstatement would reasonably
influence the decision of a user of accounts.
3 B When the sale has been completed and the customer has accepted the goods. At this point the debt is legally
enforceable.
4 Both (a) and (b) are false. A balanced or 'neutral' approach should be adopted, the objective being to produce a 'true
presentation'.
5 (1) Original cost
(2) Original cost, written down across its useful life
(3) Secondhand value
(4) Replacement cost of an identical machine
(5) Replacement cost of a more modern machine
(6) Economic value
6 D Correct. This is the characteristic of a financial capital system.
A This describes one of the key elements of a system of current cost accounting.
B Under historic accounting, net profit equals the increase in net assets for the period. If no drawings are made,
financial capital will increase.
C This reflects a system of capital maintenance in real terms.
Now try the questions below from the Question Bank
Question numbers Page
23–29 396
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114 7: Preparing accounts: concepts and conventions ⏐ Part B Accounting systems and accounts preparation
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115
Accruals and
prepayments
Introduction
Profit is the excess of income over expenses. But it is not always immediately clear how
much income and expenses are. A variety of difficulties can arise in measuring them. The
purpose of this chapter is to describe some of these problems and their solutions.
We shall consider the accounting treatment of accruals and prepayments. Their common
feature is that they are applications of the accruals concept or matching concept described in
Chapter 7.
Topic list Syllabus references
1 Accruals D (1)
2 Prepayments D (1)
3 Accounting for accruals and prepayments D (1)
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116 8: Accruals and prepayments ⏐ Part B Accounting systems and accounts preparation
1 Accruals
1.1 introduction
The accruals concept says that income and expenses should be included in the income statement of the period in which
they are earned or incurred, not paid or received.
Expenses might not be paid for during the period to which they relate. For example, a business rents a shop for $20,000
per annum, paid in full on 1 July each year. If we calculate the profit of the business for the first six months of the year
20X7, the correct charge for rent in the income statement will be $10,000 even though nothing has been paid in that
period. Similarly, the rent charge in the second six months of the year is $10,000, even though $20,000 is paid in that
period.
Accruals and prepayments can seem difficult at first, but the following examples will clarify the principle involved: that
expenses are matched against the period to which they relate.
Accruals and prepayments are the means by which we move charges into the correct accounting period. If we pay in this
period for something which relates to the next accounting period, we use a prepayment to transfer that charge forward
to the next period. If we have incurred an expense in this period which will not be paid for until the next period, we use
an accrual to bring the charge back into this period.
1.2 Accruals
Accruals or accrued expenses are expenses which are charged against the profit for a particular period, even though
they have not yet been paid for.
Accruals are current liabilities.
1.3 Example: accruals
Horace Goodrunning, trading as Goodrunning Motor Spares, ends his financial year on 28 February each year. His
telephone was installed on 1 April 20X6 and he receives his telephone account quarterly at the end of each quarter. He
pays it promptly as soon as it is received. On the basis of the following data, calculate the telephone expense to be
charged to the income statement for the year ended 28 February 20X7.
Goodrunning Motor Spares – telephone expenses paid.
$
30.6.20X6 23.50
30.9.20X6 27.20
31.12.20X6 33.40
31.3.20X7 36.00
FA
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FA
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Key term
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Part B Accounting systems and accounts preparation ⏐ 8: Accruals and prepayments 117
Solution
The telephone expenses for the year ended 28 February 20X7.
$
1 March – 31 March 20X6 (no telephone)
0.00
1 April – 30 June 20X6
23.50
1 July – 30 September 20X6
27.20
1 October – 31 December 20X6
33.40
1 January – 28 February 20X7 (two months)
24.00
108.10
The charge for the period 1 January – 28 February 20X7 is two-thirds of the quarterly bill received on 31 March. As at 28
February 20X7, no telephone bill has been received because it is not due for another month. However, it is inappropriate
to ignore the telephone expenses for January and February, and so an accrual is charged of $24.
The accrued charge will also appear in the statement of financial position of the business as at 28 February 20X7, as a
current liability.
1.4 Example: accruals
Cleverley started in business as a paper plate and cup manufacturer on 1 January 20X2, making up accounts to 31
December 20X2. Electricity bills received were as follows.
20X2 20X3 20X4
$ $ $
31 January – 6,491.52 6,753.24
30 April 5,279.47 5,400.93 6,192.82
31 July 4,663.80 4,700.94 5,007.62
31 October 4,117.28 4,620.00 5,156.40
What should the electricity charge be for the year ended 31 December 20X2?
Solution
The three invoices received during 20X2 totalled $14,060.55, but this is not the full charge for the year: the November
and December electricity charge was not invoiced until the end of January. To show the correct charge for the year, it is
necessary to accrue the charge for November and December based on January's bill. The charge for 20X2 is:
$
Paid in year
14,060.55
Accrual (
2
/
3
× $6,491.52)
4,327.68
18,388.23
The double entry for the accrual (using the journal) will be:
DEBIT Electricity account $4,327.68
CREDIT Accruals (liability) $4,327.68
2 Prepayments
Prepayments are payments which have been made in one accounting period, but should not be charged against profit
until a later period, because they relate to that later period.
Accruals are current liabilities and prepayments are current assets in the statement of financial position.
Key term
Assessment
focus point
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118 8: Accruals and prepayments ⏐ Part B Accounting systems and accounts preparation
2.1 Example: prepayments
A business opens on 1 January 20X4 in a shop which is on a 20 year lease. The rent is $20,000 per year and is payable
quarterly in advance. Payments were made on what are known as the 'quarter-days' (except the first payment) as follows.
$
1 January 20X4 5,000.00
25 March 20X4 5,000.00
24 June 20X4 5,000.00
29 September 20X4 5,000.00
25 December 20X4 5,000.00
What will the rental charge be for the year ended 31 December 20X4?
Solution
The total amount paid in the year is $25,000. The yearly rental, however, is only $20,000. The last payment was almost
entirely a prepayment (give or take a few days) as it is payment in advance for the first three months of 20X5. The charge
for 20X4 is therefore:
$
Paid in year
25,000.00
Prepayment
(5,000.00
)
20,000.00
The double entry for this prepayment is:
DEBIT Prepayments (asset) $5,000.00
CREDIT Rent account $5,000.00
3 Accounting for accruals and prepayments
3.1 Double entry for accruals and prepayments
You can see from the double entry shown for both the above examples that the other side of the entry is taken to an
asset or a liability account.
• Prepayments are included in receivables in current assets in the statement of financial position. They are
assets as they represent money that has been paid out in advance of the expense being incurred.
• Accruals are included in payables in current liabilities as they represent liabilities which have been
incurred but for which no invoice has yet been received.
Transaction DR CR Description
Accrual Expense Liability Expense incurred in period, not recorded
Prepayment Asset (Reduction in) expense Expense recorded in period, not incurred until next period
3.2 Reversing accruals and prepayments in subsequent periods
Accruals and prepayments are reversed at the beginning of the next accounting period.
FA
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Part B Accounting systems and accounts preparation ⏐ 8: Accruals and prepayments 119
The double entry will be reversed in the following period, otherwise the organisation will charge itself twice for the same
expense (accruals) or will never charge itself (prepayments). It may help to see the accounts in question. These are the
postings for the example in 1.4.
ELECTRICITY ACCOUNT
20X2
$
20X2
$
30.4
Cash
5,279.47
31.12
I/S
18,388.23
31.7
Cash
4,663.80
31.10
Cash
4,117.28
31.12
Balance c/d (accrual)
4,327.68
18,388.23
18,388.23
20X3
20X3
31.1
Cash
6,491.52
1.1
Balance b/d
30.4
Cash
5,400.93
(accrual reversed)
4,327.68
31.7
Cash
4,700.94
31.12
I/S
21,387.87
31.10
Cash
4,620.00
31.12
Balance c/d (accrual)
4,502.16
25,715.55
25,715.55
The income statement charge and accrual for 20X3 can be checked as follows.
Invoice paid
Proportion charged in 20X3
$
31.1.X3
6,491.52
1/3
2,163.84
30.4.X3
5,400.94
all
5,400.93
31.7.X3
4,700.94
all
4,700.94
31.10.X3
4,620.00
all
4,620.00
31.1.X4
6,753.24
2/3
4,502.16
Charge to I/S in 20X3
21,387.87
In the example in paragraph 2.1 it should be clear to you that the $5,000 rent prepaid in 20X2 will be added to by the
payments in 20X3, and the balance will then be reduced at the end of 20X3 in the same way.
Don’t worry too much about the idea of reversal. All you need to know is that accruals and prepayments are carried
forward to the next period.
Question
Accruals
Ratsnuffer deals in pest control. Its owner, Roy Dent, employs a team of eight who were paid $12,000 per annum each in
the year to 31 December 20X5. At the start of 20X6 he raised salaries by 10% to $13,200 per annum each.
On 1 July 20X6, he hired a trainee at a salary of $8,400 per annum.
He pays his work force on the first working day of every month, one month in arrears, so that his employees receive
their salary for January on the first working day in February, etc.
Required
(a) Calculate the cost of salaries charged in the income statement for the year ended 31 December 20X6.
(b) Calculate the amount actually paid in salaries during the year.
(c) State the amount of accrued salaries in the statement of financial position as at 31 December 20X6.
Assessment
focus point
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