R18.1 a Nature of accruals and prepayments
The accruals concept dictates that costs are recognized as they are incurred, not when money is paid. That is, goods and services are deemed to have been purchased on the date they are received. This gives rise to accrued expenses/accruals. Accruals are ‘payables’ in respect of services received that have not been paid for at the end of the accounting year. Accrued expenses can obviously only occur where services are paid for in arrears, such as electricity or gas.
The accruals concept also gives rise to prepaid expenses/prepayments. Prepayments are ‘receivables’ in respect of services that have been paid for but not received at the end of the accounting year. Prepayments can obviously only occur where services are paid for in advance, such as rent, local government taxes, road tax and insurance.
An accrual is ascertained on a time, or usage basis from the date of the period covered by the previous invoice to the year end. In many instances this requires an estimate to be made of the amount of the services consumed during the period between the date of the last invoice and the end of the accounting year. This may be based on any one of the following:
1 A meter reading taken at the end of the accounting year.
2 The amount consumed over a corresponding period during the current year.
3 The amount consumed during the same period of the previous year as adjusted for any change in the unit price.
In practice, final financial statements are often not prepared until well after the end of the accounting year. By that time the invoice covering the period in question is likely to have been received and can thus be used to ascertain the value of the services consumed during the relevant period.
The amount of the prepayment is ascertained by determining on a time basis how much of the last payment made during the accounting year relates to the services that will be received in the following accounting year.
Rent & rates
Rent prepaid at 1 June 20X2 =1/3 x £600 = £200
Rent prepaid at 31 May 20X3 =1/3 x £750 = £250
Rates accrued at 1 June 20X2 =2/12 x £2,040 = £340
Rates accrued at 31 May 20X3 =2/12 x £2,280 = £380
(b) Matching is an accounting principle which dictates that costs should be set against the revenue which they generate at the point in time when this arises. Prepayments and accruals are not strictly an application of the matching principle, but rather the accruals concept. However, sometimes the accruals concept and matching principle are combined and referred to as the accruals concept.
The accruals concept is defined in the Framework as follows: ‘Under this basis, the effects of transactions and other events are recognised when they occur (and not as cash or when its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements in the periods to which they relate.’ (IASC, Framework for the preparation and presentation of financial statement, 1989)
This is applied in part (a) of the answer by creating accrued and prepaid expenses at the end of each accounting year. This results in the charge to the profit & loss account for rent and rates reflecting the total value of the services that have been received during the accounting year irrespective of when they were paid.
Building occupancy costs