Accounting 9215: Development of the Accounting Model

Making Adjustments for Other Payables (Accruals) and Other Receivables (Prepayments)

Hello future accountants! This chapter is one of the most important steps in ensuring our financial records tell the truth. Don't worry if this seems tricky at first—we are simply learning how to tidy up our books at the end of the year so that all income and expenses are counted in the correct period.

The goal? To ensure our Income Statement (IS) and Statement of Financial Position (SOFP) are accurate by following the **Matching Principle**.

1. The Foundation: The Matching and Accrual Concepts

To make adjustments, we must first understand the core idea behind good accounting:

The Accrual Concept

In accounting, we record transactions when they happen, not when the cash moves. This is called the Accrual Basis.

  • Example: If you use the telephone service in December, the expense belongs to December, even if you don't pay the bill until January.
The Matching Principle

This principle states that for any given accounting period, the expenses incurred must be matched against the revenue they helped to generate in that exact same period.

Adjustments are necessary when cash payments or receipts don't line up perfectly with the period in which the expense or revenue was actually used or earned.

Quick Review: We adjust accounts to ensure the IS shows the true economic activity for the year, regardless of when the bills were paid!

2. Other Payables: Expenses Accrued (Accruals)

What is an Other Payable (Accrual)?

An accrual is an expense that has been incurred (used or consumed) during the current accounting period, but the cash payment has not yet been made.

  • Analogy: Imagine your business paid wages every Friday, but the financial year ends on a Wednesday. You owe your staff wages for Monday, Tuesday, and Wednesday, but you won't pay them until Friday.
  • Classification: Accruals are money owed by the business, so they are classified as Current Liabilities in the Statement of Financial Position (SOFP).

How to Make the Ledger Adjustment

When we discover an accrual, we need to increase the expense in the Income Statement and create a liability on the Balance Sheet.

Step-by-Step Double Entry for Accruals

Let's say we owe $200 for electricity used in December (our current year), but the bill comes in January (next year).

  1. Increase the Expense: We debit the relevant Expense Account (e.g., Electricity Account) to show the true cost of $200 for the year.

    \( \text{DEBIT: Expense Account (e.g., Electricity)} \)

  2. Create the Liability: We credit a new liability account, Other Payables (Accruals), to show that we owe this $200.

    \( \text{CREDIT: Other Payables Account (SOFP Liability)} \)

Impact on Financial Statements
  • Income Statement (IS): The total expense shown will now include the $200 accrual.
  • Statement of Financial Position (SOFP): The $200 will appear under Current Liabilities.

Key Takeaway: Accruals increase the expense reported for the period and create a liability.

3. Other Receivables: Expenses Paid in Advance (Prepayments)

What is an Other Receivable (Prepayment)?

A prepayment is an expense that has been paid for in advance, but the full service or goods will only be used or consumed in the next accounting period.

  • Analogy: You paid $1,200 for 12 months of insurance on December 1st. If your financial year ends December 31st, you have only used 1 month ($100). The remaining 11 months ($1,100) are a prepayment for next year.
  • Classification: The business has a right to future services/benefits because they have already paid cash. This is classified as a Current Asset in the Statement of Financial Position (SOFP).

How to Make the Ledger Adjustment

When we identify a prepayment, we need to reduce the expense recorded in the current year and create an asset.

Step-by-Step Double Entry for Prepayments

Using the insurance example above: We paid $1,200, but only $100 relates to this year. We need to reduce the Expense Account by $1,100.

  1. Decrease the Expense: We credit the relevant Expense Account (e.g., Insurance Account) to remove the portion ($1,100) that relates to the next period.

    \( \text{CREDIT: Expense Account (e.g., Insurance)} \)

  2. Create the Asset: We debit a new asset account, Other Receivables (Prepayments), to show the business owns the right to future service.

    \( \text{DEBIT: Other Receivables Account (SOFP Asset)} \)

Impact on Financial Statements
  • Income Statement (IS): The expense shown will be reduced to the correct amount ($100 in our example).
  • Statement of Financial Position (SOFP): The $1,100 will appear under Current Assets.

Key Takeaway: Prepayments decrease the expense reported for the period and create a current asset.

4. Ledger Entries and Final Statement Presentation

The Structure of the Expense Ledger Account

Every expense account (e.g., Rent, Insurance, Wages) needs to be adjusted before being closed off to the Income Statement.

Example: Rent Account Adjustment (Prepayment)

Imagine the Rent Account shows a total debit balance of $10,000 paid during the year. We determine that $1,000 of this amount is for the next period (a prepayment).

| Date | Details | $ | Date | Details | $ | | :--- | :--- | :--- | :--- | :--- | :--- | | DR (Increase) | | | CR (Decrease) | | | | Balance b/d (Total paid) | 10,000 | Other Receivables (Prepayment) | 1,000 | | | | Income Statement (The True Expense) | 9,000 | | **Totals** | **10,000** | **Totals** | **10,000** |

After the adjustment, the balance transferred to the Income Statement is the true expense ($9,000).

Key Double Entry Rules Summary

The adjustment entry always involves two accounts: the Expense/Revenue Account and the Asset/Liability Account (Other Payables/Receivables).

| Adjustment Type | Current Period Effect | Ledger Entry | SOFP Classification | | :--- | :--- | :--- | :--- | | Other Payables (Accruals) | Increases the Expense | DR Expense, CR Other Payables | Current Liability | | Other Receivables (Prepayments) | Decreases the Expense | DR Other Receivables, CR Expense | Current Asset |

Presentation in Financial Statements

Income Statement (IS) Extract

The IS always shows the Adjusted Expense Figure (the cost strictly related to the current period).

\( \text{Cost of Sales and Expenses} \)

Rent Expense (Adjusted figure after prepayment removal) \$9,000
Electricity Expense (Adjusted figure after accrual added) \$3,200

Statement of Financial Position (SOFP) Extract

The SOFP carries the balances that represent assets and liabilities for the next period.

Current Assets:
Other Receivables (Prepayments) (e.g., Prepaid Rent) \$1,000

Current Liabilities:
Other Payables (Accruals) (e.g., Accrued Electricity) \$200


🚨 Common Mistakes to Avoid 🚨

1. Confusing Prepayment and Accrual:
Trick: If the business Owes (O=Other Payables, Liability). If the business has Paid too much (P=Prepayment, Asset).

2. Debit/Credit Error:
Remember: Assets increase with a Debit (DR). Liabilities increase with a Credit (CR). If you are creating a new asset (prepayment), you must DR the Other Receivables Account!

3. Transferring the Wrong Amount to the IS:
Only the figure that represents the actual cost incurred this year goes to the Income Statement. The prepaid/accrued amount goes to the SOFP.


Did you know?

The adjustment process ensures that the fundamental accounting equation remains balanced: \( \text{Assets} = \text{Liabilities} + \text{Capital} \). By correctly identifying whether a payment is an asset (prepaid) or a liability (accrued), we maintain this crucial balance.