Year-End Accruals and Prepayments at Larkfield Traders
Larkfield Traders prepares accounts to 31 December. On 1 April 20X5 it paid £4,800 for 12 months' insurance. Rent is £3,000 per month, payable monthly in advance; the January 20X6 payment was made on 30 December 20X5. Electricity is billed quarterly: £1,500 for the quarter to 28 February, £1,650 to 31 May, £1,800 to 31 August and £1,950 to 30 November. The opening electricity accrual at 1 January 20X5 was £650, included in the first bill. The December 20X5 electricity usage is estimated at £700 and no bill has arrived. The bookkeeper has recorded all payments as expenses and has not made any year-end adjustments. The draft profit is £48,000 before these adjustments. The owner wants to know the true expenses and the closing accruals and prepayments, and is concerned that the draft profit looks lower than expected.
1. Calculate the insurance, rent and electricity expenses for the year ended 31 December 20X5, and the closing prepayments and accrual. Show your workings.
Read the worked answer
Insurance: The £4,800 covers 12 months from 1 April 20X5, so 9 months relate to 20X5: £4,800 × 9/12 = £3,600. The remaining £1,200 is a prepayment at 31 December 20X5.
Rent: The expense is 12 months × £3,000 = £36,000. The payment made on 30 December 20X5 is for January 20X6, so it is not a 20X5 expense; £3,000 is a prepayment. Cash paid is £39,000, but the accrual basis matches the expense to the period of use.
Electricity: Cash paid is £1,500 + £1,650 + £1,800 + £1,950 = £6,900. The opening accrual of £650 was last year's expense included in the first bill, so deduct it. Add the £700 closing accrual for December. Expense = £6,900 − £650 + £700 = £6,950.
Totals: Expenses = £3,600 + £36,000 + £6,950 = £46,550. Prepayments = £1,200 + £3,000 = £4,200. Accrual = £700.
2. Explain why the opening electricity accrual is deducted in the calculation and state the effect on profit and net assets if the closing electricity accrual is omitted.
Read the worked answer
The opening accrual is deducted because the first electricity bill includes December 20X4 usage, which was already charged as an expense in 20X4. Including the whole bill in 20X5 would double-count that month and understate 20X5 profit. The matching principle requires the expense to follow the period of consumption, not the cash payment.
If the closing accrual of £700 is omitted, 20X5 electricity expense is understated by £700, so profit is overstated by £700. Liabilities are understated by £700 and net assets are correspondingly overstated. The error does not affect cash, but it misstates the accruals figure and the current liabilities in the statement of financial position.
3. The owner asks whether the rent paid on 30 December 20X5 can be treated as an expense of 20X5 because cash has left the business. Advise.
Read the worked answer
Cash leaving the business does not make the rent a 20X5 expense. Under the accrual basis, the £3,000 paid on 30 December 20X5 relates to January 20X6 and must be carried forward as a prepayment. Treating it as a 20X5 expense would overstate 20X5 rent by £3,000 and understate profit; it would also understate prepayments and net assets.
The cash book balance is unaffected, but the year-end adjustment Dr Prepayments £3,000 / Cr Rent expense £3,000 is needed. If the owner wants to see cash flow, that is a separate statement; the income statement follows usage.