CIMA - C2 Fundamentals of Financial Accounting

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120 8: Accruals and prepayments ⏐ Part B Accounting systems and accounts preparation

Answer

(a) Salaries cost in the income statement

Cost of 8 employees for a full year at $13,200 each

105,600

Cost of trainee for a half year

4,200

109,800

(b) Salaries actually paid in 20X6

December 20X5 salaries paid in January (8 employees × $1,000 per month)

8,000

Salaries of 8 employees for January – November 20X6 paid in February – December (8

employees × $1,100 per month × 11 months)

96,800

Salary of trainee (for July – November paid in August – December

20X6: 5 months × $700 per month)

3,500

Salaries actually paid

108,300

(ie costs charged in the I/S, but not yet paid)

8 employees x 1 month x $1,100 per month

8,800

1 trainee x 1 month x $700 per month

700

9,500

(d) Summary

Accrued wages costs as at 31 December 20X5

8,000

Add salaries cost for 20X6 (I/S)

109,800

117,800

Less salaries paid

108,300

Equals accrued wages costs as at 31 December 20X6

9,500

3.3 Example: prepayments

The Square Wheels Garage pays fire insurance annually in advance on 1 June each year. From the following record of

insurance payments, calculate the charge to the income statement for the financial year to 28 February 20X8.

Insurance paid

1.6.20X6 600

1.6.20X7 700

Solution

Insurance cost for:

(a)

the 3 months, 1 March – 31 May 20X7 (3/12 × $600)

150

(b)

the 9 months, 1 June 20X7 – 28 February 20X8 (9/12 × $700)

525

Insurance cost for the year, charged to the I/S

675

At 28 February 20X8 there is a prepayment for fire insurance, covering the period 1 March – 31 May 20X8. This

insurance premium was paid on 1 June 20X7, but only nine months worth of the full annual cost is charged in the

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Part B Accounting systems and accounts preparation ⏐ 8: Accruals and prepayments 121

accounting period ended 28 February 20X8. The prepayment of (3/12 × $700) $175 appears as a current asset in the

statement of financial position of the Square Wheels Garage.

In the same way, there was a prepayment of (3/12 × $600) $150 in the statement of financial position one year earlier as

at 28 February 20X7.

Summary

Prepaid insurance premiums as at 28 February 20X7

150

Add insurance premiums paid 1 June 20X7

700

850

Less insurance costs charged to the I/S for the year ended 28 February 20X8

675

Equals prepaid insurance premiums as at 28 February 20X8

175

Question

Accruals and prepayments

The Batley Print Shop rents a photocopying machine for which it makes a quarterly payment as follows.

• Three months rental in advance

• A further charge of 2 pence per copy made during the quarter just ended

The rental agreement began on 1 August 20X4 and the first six quarterly bills were as follows.

Bills dated and received Rental Costs of copies taken Total

$ $ $

1 August 20X4 2,100 0 2,100

1 November 20X4 2,100 1,500 3,600

1 February 20X5 2,100 1,400 3,500

1 May 20X5 2,100 1,800 3,900

1 August 20X5 2,700 1,650 4,350

1 November 20X5 2,700 1,950 4,650

The bills are paid promptly, as soon as they are received.

(a) Calculate the charge for photocopying expenses for the year to 31 August 20X4 and the amount of prepayments

and/or accrued charges as at that date.

(b) Calculate the charge for photocopying expenses for the following year to 31 August 20X5, and the amount of

prepayments and/or accrued charges as at that date.

Answer

(a) Year to 31 August 20X4

One months' rental (1/3 × $2,100) *

700

Accrued copying charges (1/3 × $1,500) **

500

Photocopying expense (I/S)

1,200

* From the quarterly bill dated 1 August 20X4

** From the quarterly bill dated 1 November 20X4

There is a prepayment for 2 months' rental ($1,400) and an accrual ($500) for copying charges as at 31 August

20X4.

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122 8: Accruals and prepayments ⏐ Part B Accounting systems and accounts preparation

(b) Year to 31 August 20X5

Rental from 1 September 20X4 – 31 July 20X5 (11 months at

$2,100 per quarter or $700 per month)

7,700

Rental from 1 August – 31 August 20X5 (1/3 × $2,700)

900

Rental charge for the year

8,600

Copying charges

1 September – 31 October 20X4 (2/3 × $1,500)

1,000

1 November 20X4 – 31 January 20X5

1,400

1 February – 30 April 20X5

1,800

1 May – 31 July 20X5

1,650

Accrued charges for August 20X5 (1/3 × $1,950)

650

6,500

Total photocopying expenses (I/S)

15,100

There is a prepayment for 2 months' rental ($1,800) and an accrual for copying charges ($650) as at 31 August

20X5.

Summary of year 1 September 20X4 – 31 August 20X5

Rental charges

Copying costs

Prepayments as at 31.8.20X4

1,400

Accrued charges as at 31.8.20X4

(500)

Bills received during the year

1 November 20X4

2,100

1,500

1 February 20X5

2,100

1,400

1 May 20X5

2,100

1,800

1 August 20X5

2,700

1,650

Prepayment as at 31.8.20X5

(1,800)

Accrued charges as at 31.8.20X5

650

Charge to the I/S for the year

8,600

6,500

SOFP items as at 31 August 20X5

Prepaid rental (current asset)

1,800

Accrued copying charges (current liability)

650

3.4 Further example: accruals

Willie Woggle opens a shop on 1 May 20X6. The rent of the shop is $12,000 per annum, payable quarterly in arrears (with

the first payment on 31 July 20X6). Willie decides that his accounting period should end on 31 December each year.

The rent account as at 31 December 20X6 will record only two rental payments (on 31 July and 31 October) and there

will be two months

' accrued rental expenses for November and December 20X6 ($2,000). The charge to the I/S for the

period to 31 December 20X6 will be for 8 months

' rent (May-December inclusive) ie $8,000.

The rent account appears as follows.

RENT EXPENSE ACCOUNT

$ $

20X6 20X6

31 July Cash 3,000

31 Oct Cash 3,000 31 Dec I/S 8,000

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Part B Accounting systems and accounts preparation ⏐ 8: Accruals and prepayments 123

The accrual of $2,000 has to be put in to bring the balance in the account up to the full charge for the year. At the

beginning of the next year the accrual is reversed.

RENT EXPENSE ACCOUNT

20X6

31 July

Cash

3,000

31 Oct

Cash

3,000

31 Dec

Balance c/d (accruals)

2,000

31 Dec

I/S

8,000

19X7

1 Jan

Balance b/d

(accrual reversed)

2,000

The rent account for the next year to 31 December 20X7, assuming no increase in rent in that year, would be as follows.

RENT EXPENSE ACCOUNT

20X7

31 Jan

Cash

3,000

1 Jan

Balance b/d

30 Apr

Cash

3,000

(accrual reversed)

2,000

31 Jul

Cash

3,000

31 Oct

Cash

3,000

31 Dec

Balance c/d (accruals)

2,000

31 Dec

I/S

12,000

14,000

20X8

1 Jan

Balance b/d

(accrual reversed)

2,000

Here you will see that, for a full year, a full twelve months' rental charges are taken as an expense to the income

statement. The accrual appears as a credit balance on the account and is, therefore, shown on the statement of financial

position as a liability.

3.5 Further example: prepayments

Terry Trunk commences business as a landscape gardener on 1 September 20X5. He joins his local trade association,

the Confederation of Luton Gardeners, at an annual membership subscription of $180, payable annually in advance. He

paid this amount on 1 September. Terry decides that his account period should end on 30 June each year.

In the first period to 30 June 20X6 (10 months), a full year

's membership will have been paid, but only ten twelfths of the

subscription is charged to the period (ie

10/12 × $180 = $150). There is a prepayment of two months of membership

subscription (ie

2/12 × $180 = $30).

The prepayment is recognised in the ledger account for subscriptions by using the balance carried down/brought down

technique.

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124 8: Accruals and prepayments ⏐ Part B Accounting systems and accounts preparation

SUBSCRIPTIONS EXPENSE ACCOUNT

20X5

20X6

1 Sept

Cash

180

30 Jun

I/S

150

30 Jun

Balance c/d

(prepayment)

180

20X6

1 Jul

Balance b/d

(prepayment reversed)

The subscription account for the next year, assuming no increase in the annual charge and that Terry Trunk remains a

member of the association, will be as follows.

SUBSCRIPTIONS EXPENSE ACCOUNT

20X6

20X7

1 Jul

Balance b/d

30 Jun

I/S

180

(prepayment reversed)

30 Jun

Balance c/d

1 Sep

Cash

180

(prepayment)

210

20X7

1 Jul

Balance b/d

(prepayment reversed)

Again, we see the charge to the I/S is for a full year's subscription. The credit balance represents the prepayment which

will be debited to prepayments and will appear as an asset on the statement of financial position.

Chapter roundup

• 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.

• 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.

• Accruals and prepayments are reversed at the beginning of the next accounting period.

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Part B Accounting systems and accounts preparation ⏐ 8: Accruals and prepayments 125

Quick quiz

1 If a business has paid rent of $1,000 for the year to 31 March 20X9, the prepayment in the accounts for the year to 31

December 20X8 is $ _________________.

2 _______________________ in the statement of financial position are amounts incurred but not yet paid.

_______________________ in the statement of financial position are amounts paid but not yet incurred.

(Fill in the blanks.)

3 A draft income statement shows a gross profit of $2,000 and net profit of $1,000. It is then realised that $400 of rent

that should be treated as a prepayment has been incorrectly treated as an accrual. When this mistake is corrected what

happens to gross and net profit?

Gross profit Net profit

A No change No change

B Falls $400 Falls $400

C Falls $400 Rises $400

D No change Rises $800

4 A business pays $2,400 for a year's insurance on 1 December 20X1. The year end is 31 March 20X2. At that date, what

is the balance carried forward on the insurance account?

A $800 debit

B $800 credit

C $1,600 debit

D $1,600 credit

5 A business prepares its accounts to 31 December 20X7. The trial balance includes $9,000 for electricity used from 1

January to 30 September 20X7. How much needs to be accrued at the year end?

A $9,000

B $3,000

C $6,000

D $12,000

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126 8: Accruals and prepayments ⏐ Part B Accounting systems and accounts preparation

Answers to quick quiz

1 $250 (3/12 × $1,000)

2 Accruals are amounts incurred but not yet paid. Prepayments are amounts paid but not yet incurred.

3 D There is no change in gross profit. Net profit has been charged with $400 accrual instead of a prepayment, so we

need to reduce costs by $400 to reverse the accrual and a further $400 to reinstate the prepayment. Therefore net

profit will rise by $800.

4 D The prepayment is 8 months ie $1,600 (8/12 × $2,400). This will be c/f as a credit (reducing the amount charged

to the income statement by $1,600).

5 B The accrual is 3/9 × $9,000 ($3,000).

Now try the questions below from the Question Bank

Question numbers Page

30–32 397

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127

Topic list Syllabus references

1 Depreciation D (3)

2 Revaluation of non-current assets D (3)

3 Non-current asset disposals D (3)

4 The non-current assets register D (4)

Non-current assets

–

depreciation,

revaluation and disposal

Introduction

You are familiar with the distinction between non-current and current assets, a non-current

asset being one bought for ongoing use in the business. (If you are unsure look back to

Chapter 2.)

Non-current assets are held and used by a business for a number of years, but they wear out

or lose their usefulness over time. Every tangible non-current asset has a limited life. The

only exception is land held freehold or on a very long leasehold.

The accounts of a business recognise that the cost of a non-current asset is consumed as the

asset wears out, by writing off the asset's cost in the income statement over several

accounting periods. For example, a machine costs $1,000 and is expected to wear out after

ten years. We can reduce the statement of financial position value by $100 each year. This

process is known as depreciation. Depreciation is the subject of a reporting standard (IAS

16). Although you do not need to know IAS 16 specifically as such, the key principles are

relevant. This is discussed in Section 1.

Generally the market value of a non-current asset, particularly land or buildings, will rise with

time. The asset may then be revalued. The accounting treatment of revaluations and the

effect on depreciation are considered in Section 2. Section 3 deals with disposals of non-

current assets. A profit or loss may arise on the sale of a non-current asset.

Section 4 deals with a more practical issue: the non-current assets register. You are sure to

encounter this in real life, nearl

all or

anisations have one.

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128 9: Non-current assets – depreciation, revaluation and disposal ⏐ Part B Accounting systems and accounts preparation

1 Depreciation

The cost of a non-current asset, less its estimated residual value, is allocated fairly between accounting periods by

means of depreciation. The provision for depreciation is charged against profit and deducted from the value of the non-

current asset in the statement of financial position.

Since a non-current asset has a cost, a limited useful life and a declining value, a charge is made in the income

statement to reflect the use. This charge is called depreciation. Depreciation is a means of spreading the cost of a non-

current asset over its useful life. This matches the cost against the period over which it earns profits for the business

(the accruals concept).

1.1 Non-current assets and depreciation

A non-current asset is acquired with a view to earning profits. Its life extends over more than one accounting period,

and so it earns profits over more than one period. With the exception of land held on freehold or very long leasehold,

every non-current asset eventually wears out over time. Machines, cars and other vehicles, fixtures and fittings, and even

buildings do not last for ever. When a business acquires a non-current asset, it will have some idea about how long its

useful life will be. Its policy may be one of the following.

• Use the non-current asset until it is worn out, useless, and worthless

• Sell off the non-current asset at the end of its useful life as second-hand or as scrap

1.2 Example: depreciation

A business buys a machine for $40,000. Its expected life is four years, and at the end of that time it is expected to be

worthless. Calculate the annual depreciation charge.

Solution

Since the non-current asset will earn profits for four years, it seems reasonable to charge the cost of the asset over

those four years at $10,000 per annum. (By the end of the four years, the total cost will have been written off against

profits.)

1.3 IAS 16 Property, plant and equipment

The CA 2006 requires that all non-current assets having a limited useful life should be depreciated. IAS 16 Property,

plant and equipment gives a useful discussion of the purpose of depreciation and supplements the statutory

requirements in important respects.

Depreciation can be defined as

'the measure of the cost or revalued amount of the economic benefits of the tangible

non-current asset that have been consumed during the period. Consumption includes the wearing out, using up or other

reduction in the useful life of a tangible non-current asset whether arising from use, effluxion (passing) of time or

obsolescence through either changes in technology or demand for the goods and services produced by the asset'.

Net book value is cost (or revalued amount) less depreciation to date.

Key term

Key terms

T F

RWAR

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Part B Accounting systems and accounts preparation ⏐ 9: Non-current assets – depreciation, revaluation and disposal 129

Question

Depreciation

A business buys a machine on 1 January 20X2 for $10,000. It expects to use it for 4 years and then sell it for $2,000.

Calculate the annual depreciation charge and the net book value at 31 December 20X2, 20X3, 20X4 and 20X5 (the

expected sale date).

Answer

The annual depreciation charge is

000,2–000,10$

= $2,000

Depreciation Net book value

Cost to date

$ $ $

31 December 20X2 10,000 2,000 8,000

31 December 20X3 10,000 4,000 6,000

31 December 20X4 10,000 6,000 4,000

31 December 20X5 10,000 8,000 2,000

The net book value (NBV) of an asset is not equal to its net realisable value and so the object of depreciation is not to

reflect the fall in value of an asset over its life.

Another misconception is that depreciation provides funds to replace the asset at the end of its useful life. This is not the

case, there is no movement of cash when depreciation is calculated and charged in the income statement.

The

depreciable amount

is the total amount to be charged over the life of a non-current asset, usually its cost less any

expected 'residual' sales or disposal value at the end of its life.

1.4 Calculating depreciation

IAS 16 states factors that need to be considered in determining the useful life, residual value and depreciation method of

an asset.

•

Expected usage

with reference to the asset's expected capacity or physical output

•

Expected physical deterioration

through use or passing of time

•

Economic or technological obsolescence

(eg typesetters replaced by word processors)

•

Legal or similar limits

on the use of the asset (eg the expiry date of a lease)

The cost at which non-current assets are to be stated in the accounts is defined by the CA1985 and is, broadly speaking,

purchase price or manufacturing cost, plus incidental expenses.

The estimated residual value of an asset is a matter of judgement. If it is expected to be a relatively small amount in

relation to the asset

's cost, it is usually taken to be nil.

The expected life of an asset is again a matter of judgement. IAS 16 comments that an asset

's useful life may be affected

by the following points.

•

Pre-determined (eg leaseholds)

•

Directly governed by extraction or consumption (eg a mine or quarry)

•

Dependent on the extent of use (eg a motor car)

•

Reduced by economic or technological obsolescence (eg last year's fashions)

Key term

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