Year-End Accruals, Prepayments and Profit
At 31 March, the first draft accounts of Daley Consultancy show a profit of $46,800. You find the following. Rent of $22,000 was paid during the year; it includes $4,000 relating to the three months to 30 June next. Insurance of $9,600 was paid for the twelve months to 30 June next. Electricity paid was $5,200; the last invoice, for the quarter to 31 January, was $1,350, and usage is even through the year. Wages paid were $48,000; the last week of March, $1,800, will be paid in April. The owner has already recorded the rent and insurance payments as expenses in full and has made no year-end adjustments. He argues that because the cash has gone out, the accounts are 'accurate enough' and that adjusting entries only matter for large companies.
1. Calculate the corrected profit for the year, showing each adjustment.
Read the worked answer
| Item | $ |
|---|---|
| Draft profit | 46,800 |
| Rent prepaid: 22,000 - 4,000 = 18,000 expense | +4,000 |
| Insurance prepaid: 9,600 x 3/12 = 2,400 | +2,400 |
| Electricity accrued: 1,350 / 3 = 450 per month; 2 months = 900 | (900) |
| Wages accrued | (1,800) |
| Corrected profit | 50,500 |
Reasoning: the rent expense for the year is $18,000 because $4,000 relates to April to June next year; that $4,000 is a prepayment, not an expense. Insurance covers twelve months to 30 June, so three months ($2,400) are prepaid and the expense is $7,200. Electricity: the last invoice covers a quarter at $1,350, so monthly usage is $450; February and March are unrecorded, giving an accrual of $900 and total expense of $6,100. Wages of $1,800 for the last week of March are an accrual, so the wages expense is $49,800. Profit is therefore $50,500, not $46,800.
2. Write the adjusting journal entries at 31 March, including the entries to record the prepayments and accruals.
Read the worked answer
| Adjustment | Dr | Cr |
|---|---|---|
| Rent prepaid | Prepaid rent 4,000 | Rent expense 4,000 |
| Insurance prepaid | Prepaid insurance 2,400 | Insurance expense 2,400 |
| Electricity accrued | Electricity expense 900 | Accrued expenses 900 |
| Wages accrued | Wages expense 1,800 | Accrued wages 1,800 |
Prepaid rent and prepaid insurance are current assets: the business has paid for benefits it will receive next year. The accrued electricity and wages are current liabilities: the business has consumed the benefit but not yet paid. The entries reduce the expense accounts for the prepayments and increase them for the accruals. On the balance sheet, prepayments increase assets by $6,400, while accruals increase liabilities by $2,700. The net effect on profit is an increase of $3,700, matching the difference between the draft and corrected profit. These entries should be reversed or reviewed at the start of the next period so that next year's expenses are not double-counted.
3. The owner argues that because cash has been paid, no adjustment is needed and that adjustments only matter for large companies. Respond, referring to the accrual basis and materiality.
Read the worked answer
The owner is applying a cash basis, which is not acceptable for financial statements prepared under accounting standards. The accrual basis matches expenses with the period that benefited from them. Rent and insurance paid in advance are assets at 31 March, not expenses of the current year. Electricity and wages consumed but unpaid are liabilities and expenses of the current year. Omitting the adjustments understates profit by $3,700 and misstates both assets and liabilities, so the accounts would not be 'accurate enough'.
Size is not the test. Materiality is about whether omission or misstatement could influence a user's decisions. Here the net adjustment is about 8% of draft profit, which is material for a small consultancy; the balance sheet effects are also significant. Even if an item were immaterial, that would be a reason for simplified presentation, not for ignoring the accrual basis entirely. The owner should also consider tax: understating profit may understate tax, but incorrect accounts can lead to penalties or amended returns. Adjusting entries are part of good record-keeping at any size.