Adjustments and accounting principles (accruals, prepayments, depreciation, irrecoverable debts)
What the exam tests
This domain tests year-end adjustments under the accruals basis: accruals, prepayments, depreciation, disposals, irrecoverable debts and allowances for receivables. You must adjust the SPL and SFP and understand the matching principle.
Core rules
- Accrual: an expense incurred but not yet invoiced. Debit the expense; credit an accrual liability. Accrued income is a receivable.
- Prepayment: an expense paid in advance. Debit a prepayment asset; credit the expense. Prepaid income is a liability.
- Depreciation allocates the cost of a non-current asset over its useful life. Straight-line: (cost − residual value) ÷ useful life. Reducing balance: a fixed percentage applied to the carrying amount each year.
- On disposal, remove cost and accumulated depreciation, record proceeds, and recognise the profit or loss on disposal.
- Irrecoverable debt: debit irrecoverable debts expense; credit receivables. An allowance for receivables is a provision against remaining receivables and is adjusted through the SPL.
Worked example
On 31 December, rent paid was £22,000 for the 12 months to 31 March next year. Three months are prepaid: 3/12 × £22,000 = £5,500. The SPL charge is £16,500 and the SFP shows a prepayment of £5,500.
A machine costs £50,000, has a residual value of £5,000 and a five-year life. Straight-line depreciation is (£50,000 − £5,000) ÷ 5 = £9,000 per year.
Reasoning: only the expired portion of rent is an expense; the unused portion is an asset. Depreciation matches the asset's cost to the periods benefiting from it.
Traps
Reversing prepayments and accruals is common. Do not depreciate land. Check whether depreciation is charged for part of a year on additions. Do not write off an irrecoverable debt against an allowance twice. Remember that an allowance is not a cash payment.
Key points
- Accruals are liabilities; prepayments are assets.
- Depreciation is an allocation of cost, not a valuation.
- Remove cost and accumulated depreciation on disposal.
- Write off irrecoverable debts against receivables.
- Adjust the allowance for receivables through the SPL.