Simplified notes on accounting treatment

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Discount Received
Discounts may be offered by suppliers on sales of goods to attract buyers.
Accounting for discount received depends on the nature of discount.
Discounts may be classified into two types:
Trade Discounts: offered at the time of purchase for example when goods
are purchased in bulk or to retain loyal customers.
Cash Discount: offered to customers as an incentive for timely payment of
their liabilities in respect of credit purchases.
Trade Discount
Trade discounts are generally ignored for accounting purposes in that they are
omitted from accounting records.
Therefore, purchases, along with any payables in the case of a credit
purchase, are recorded net of any trade discounts offered.
Example
BMX LTD as part of its purchases promotion campaign has offered to sell
their bikes at a 10% discount on their listed price of $100.
Purchases and payables in respect of BMX LTD will be recorded net of trade
discount, i.e. $90 per bike.
Cash Discount
Cash discounts result in the reduction of purchase costs during the period and
the amount payable in respect of those purchases. However, not all
purchases may qualify for the cash discount. It is therefore necessary to
record the initial purchase and accounts payable at the gross amount (after
deducting any trade discounts though!) and subsequently decreasing
purchases and payables by the amount of discount that is actually received.
Following double entry is required to record the cash discount:
Debit
Payable
Credit
Discount Received (Income Statement)
Crediting discount received has the effect of reducing gross purchases by the
amount of cash discount received. Consequently, payables are debited to
reduce their balance to the amount that is expected to be paid to them, i.e. net
of cash discount.
Example
BMX LTD as part of its purchases promotion campaign has offered to sell
their bikes at a 10% discount on their listed price of $100. If customers pay
within 10 days from the date of purchase, they get a further $5 cash discount.
Bike LTD purchases a bike from BMX LTD and pays within 10 days of the
date of purchase.
Before we proceed with the accounting entries, it is necessary to first
distinguish between the two types of discounts being offered by BMX LTD.
The 10% discount is a trade discount and should therefore not appear in Bike
LTD's accounting records. The $5 discount is a cash discount and must be
dealt with accordingly.
The initial purchase of the bike will be recorded as follows:
Debit
Credit
Purchases (net of trade discount)
BMX LTD (Payable) (net of trade
discount)
$90
$90
As Bike LTD qualifies for the cash discount, the following double entry will be
required to record the discount received:
Debit
Credit
BMX LTD (Payable)
Discount Received (income
statement)
$5
$5
The above entries have resulted in purchases of Bike LTD being reduced to
$85 (100-90-5). The payable to BMX LTD has also been reduced to this
amount effectively.
Purchases Returns
Purchases returns, or returns outwards, are a normal part of business. Goods
may be returned to supplier if they carry defects or if they are not according to
the specifications of the buyer.
There is need to account for purchase returns as though no purchase had
occurred in the first place.
Hence, the value of goods returned to the supplier must be deducted from
purchases.
Where purchase was initially made on credit, the payable recognized must
also be reversed by the amount of purchases returned.
The following double entry must be made upon purchases returns:
Debit
Credit
Payable (decrease in liability)
Purchases Returns (decrease in expense)
Example
Bike LTD purchases a mountain bike from BMX LTD for $100 on credit.
Bike LTD later returns the bike to BMX LTD due to a serious defect in the
design of the bike.
The initial purchase will be recorded as follows:
Debit
Credit
Purchases
BMX LTD (Payable)
$100
$100
Upon the return of bike, the following double entry will be passed:
Debit
Credit
BMX LTD (Payable)
Purchases Return
$100
$100
No further entry will be required as the payable due to BMX LTD has been
reversed.
Discount Allowed
Discounts may be offered on sales of goods to attract buyers. Discounts may
be classified into two types:
Trade Discounts: offered at the time of purchase for example when goods
are purchased in bulk or to retain loyal customers.
Cash Discount: offered to customers as an incentive for timely payment of
their liabilities in respect of credit purchases.
Trade Discount
Trade discounts are generally ignored for accounting purposes in that they are
omitted from accounting records.
Therefore, sales, along with any receivables in the case of a credit sale, are
recorded net of any trade discounts offered.
Example
Bike LTD as part of its sales promotion campaign has offered to sell their
bikes at a 10% discount on their listed price of $100.
Sale revenue and any accounts receivable will be recorded net of trade
discount, i.e. $90 per bike.
Cash Discount
Cash discounts result in the reduction of sales revenue earned during the
period. However, not all customers may qualify for the cash discount. It is
therefore necessary to record the initial sale and receivables at the gross
amount (after deducting any trade discounts!) and subsequently decreasing
the sale revenue and accounts receivable by the amount of discount that is
actually allowed.
Following double entry is required to record the cash discount:
Debit
Credit
Discount Allowed (Income Statement)
Receivable
Debiting discount allowed ledger has the effect of reducing gross sales
revenue by the amount of cash discount allowed. Consequently, receivables
are credited to reduce their balance to the amount that is expected to be
recovered from them, i.e. net of cash discount.
Example
Bike LTD as part of its sales promotion campaign has offered to sell their
bikes at a 10% discount on their listed price of $100. If customers pay within
10 days from the date of purchase, they get a further $5 cash discount. Bike
LTD sells a bike to XYZ who pays within 10 days.
Before we proceed with the accounting entries, it is necessary to first
distinguish between the two types of discounts being offered by Bike LTD.
The 10% discount is a trade discount and should therefore not appear in Bike
LTD's accounting records. The $5 discount is a cash discount and must be
dealt with accordingly.
The initial sale of the bike will be recorded as follows:
Debit
Credit
XYZ (Receivable)
Sales
$90
$90
As XYZ qualifies for the cash discount, the following double entry will be
required to record the discount allowed:
Debit
Credit
Discount Allowed (Income
Statement)
XYZ (Receivable)
$5
$5
The above entries have resulted in sales of Bike LTD being reduced to $85
(100-90-5). The receivable from XYZ has also been reduced to this amount
effectively.
Bad Debts / Irrecoverable Debts
An entity may not be able to recover its balances outstanding in respect of
certain receivables. In accountancy we refer to such receivables as
Irrecoverable Debts or Bad Debts. Bad debts could arise for a number of
reasons such as customer going bankrupt, trade dispute or fraud.
Every time an entity realizes that it unlikely to recover its debt from a
receivable, it must 'write off' the bad debt from its books. This ensures that the
entity's assets (i.e. receivables) are not stated above the amount it can
reasonably expect to recover which is in line with the concept of prudence.
Accounting entry required to write off a bad debt is as follows:
Debit
Credit
Bad Debt Expense
Receivable
The credit entry reduces the receivable balance to nil as no amount is
expected to be recovered from the receivable. The debit entry has the effect
of cancelling the impact on profit of the sales that were previously recognized
in the income statement.
Example
ABC LTD sells goods to DEF LTD for $500 on credit. ABC LTD subsequently
finds out that DEF LTD is being liquidated and therefore the prospects of
recovering its dues are very low.
ABC LTD should write off the receivable from DEF LTD in view of the
circumstances. The double entry will be recorded as follows:
Debit
Credit
Bad Debt Expense
DEF LTD (Receivable)
$500
$500
Bad Debt Recovered
Occasionally, a bad debt previously written off may subsequently settle its
debt in full or in part. In such case, it will be necessary to cancel the effect of
bad debt expense previously recognized up to the amount settlement.
Example
ABC LTD sells goods to DEF LTD for $500 on credit. ABC LTD subsequently
finds out that DEF LTD is being liquidated and therefore the prospects of
recovering its dues are very low. ABC LTD therefore writes off the receivable
from its books. However, the administrator appointed to oversee the
liquidation of DEF LTD instructs the company to pay $300 to ABC LTD in full
settlement of its dues.
As $300 of the bad debt has been recovered, it is necessary to cancel the
effect of previously recognized bad debt expense up to this amount. The
accounting entry will therefore be as follows:
Debit
Credit
Cash/Bank
Bad Debt Recovered (Income)
$300
$300
Provision / Allowance for doubtful debts
Recoverability of some receivables may be doubtful although not definitely
irrecoverable. Such receivables are known as doubtful debts. Prudence
requires that an allowance be created to recognize the potential loss arising
from the possibility of incurring bad debts.
The allowance for doubtful debts is created by forming a credit balance which
is deducted from the total receivables balance in the statement of financial
position. This works in the same way as accumulated depreciation is
deducted from the fixed asset cost account. The allowance for doubtful debts
reduces the receivable balance to the amount that the entity prudently
estimates to recover in the future.
Allowance for doubtful debts consist of two types:

Specific Allowance

General Allowance
Specific Allowance
This is allowance created in respect of specific receivables which are known
to be facing serious financial problems or have a trade dispute with the entity.
Such balances may be identified by examining an aged receivable analysis
which details the time lapsed since the creation of a receivable. Long
outstanding balances identified from such analyses could be considered for
inclusion in the allowance for doubtful debts.
The difference between the treatment of a bad debt and a specific allowance
for doubtful debt is that in the latter case, the receivable ledger of the specific
debt is not removed in case the debtor actually pays whereas in the case of
bad debts, the receivable ledger is reduced to nil. Also, specific allowance
may not be created for the entire amount of the doubtful receivable but only a
portion of it. For instance, if there is a 50% chance of recovering a doubtful
debt in respect of a certain receivable, a specific allowance of only 50% may
be required. On the contrary, bad debt is normally recognized in full.
General Allowance
Past history of a business may show that a portion of receivable balances is
not recovered due to unforeseen circumstances. Therefore, it may be prudent
to create a general allowance for doubtful debts in addition to the specific
allowance. The general allowance may be calculated on the basis of past
experience concerning recoverability of debts.
The practice of creating general provisions is on the decline after revisions in
the International Financial Reporting Standards (IFRS). Specifically, IAS 39
prohibits creation of general provisions on the basis of past experience due to
the subjectivity involved in creating such an estimate. Instead, reporting entity
is required to carry out impairment review to determine the recoverability of
the receivables and any associated allowance.
Next page contains detail on the accounting of provision for doubtful debts.
Accounting for Doubtful Debts
Allowance for doubtful debts is created by forming a credit balance which is
netted off against the total receivables appearing in the balance sheet. A
corresponding debit entry is recorded to account for the expense of the
potential loss. Accounting entry to record the allowance for receivable is as
follows:
Debit
Credit
Allowance for Doubtful Debts (Expense)
Allowance for Doubtful Debts (Balance Sheet)
Once an allowance for doubtful debts has been created, only the movement in
the allowance will need to be charged to the income statement in future
accounting period. So if estimated allowance for doubtful debt is same as last
accounting period, no accounting entry will be required in the current period
as the total receivables will be reduced by the amount of allowance which has
already been created.
Example
ABC LTD has trade receivable of worth $50,000 as at 31 December 2010.
XYZ LTD, a receivable owing $10,000 to ABC LTD at the year end, has been
recently been wound up. Consequently, ABC LTD does not expect to recover
the amount due from XYZ LTD. Based on past experience, ABC LTD
estimates that 5% of its receivables will default. Allowance for doubtful debts
on 31 December 2009 was $1500.
ABC LTD must write off the $10,000 receivable from XYZ LTD as bad debt.
Accounting entry to record the bad debt will be as follows:
Debit
Credit
$10,000
$10,000
Bad Debt Expense
XYZ LTD (Receivable)
A general allowance of $2,000 [( 50,000-10,000) x 5%] must be made. As a
general allowance of $1500 has already been created, only $500 additional
allowance must be charged to the income statement:
Debit
Credit
Allowance for Doubtful Debts
(Expense)
Allowance for Doubtful Debts
(Balance Sheet)
$500
$500
Note that $10,000 in respect of receivable from XYZ LTD has been excluded
from the calculation of the general allowance as it has already been written off
in full.
Bad Debt Expense
Credit
$
Debit
XYZ LTD (Receivable)
10,000
Income Statement
10,000
Sales
10,000
Bad Debt Expense
10,000
Debit
2,000
Balance c/d
Income Statement
2,000
ccounts Payable
What is accounts payable?
$
10,000
10,000
Allowance for Doubtful Debts
Credit
$
Balance c/d
10,000
10,000
XYZ LTD Receivable
Credit
$
Debit
$
$
1,500
500
2,000
Accounts payable is the balance owed by the entity to its suppliers in respect
of purchase of goods and services on credit.
Accounting for Payables
Accounts payables balance is affected by the amount of credit
purchase, sales tax, discount received, purchase returns and the payments to
suppliers.
Credit Purchase
As credit purchase results in increase in the expense and liabilities of the
entity, expense must be debited while accounts payable must be credited.
Therefore in case of a credit purchase, the following double entry is recorded:
Debit
Credit
Purchases (Income Statement)
Payable
When the payable is paid his due, the payable balance will be reduced to nil.
The following double entry is recorded:
Debit
Credit
Payable
Cash/Bank
Sales Tax on Payables
The payable includes the amount of sales tax since it will be paid to the
supplier. Purchases are recorded net of sales tax because any input tax paid
on the purchases will be recovered from tax authorities and hence, does not
form part of the expense. Sales Tax account is debited since this is the
amount of sales tax recoverable from the tax authorities.
The accounting entry to record credit purchases involving sales tax will
therefore be as follows:
Debit
Debit
Credit
Sales Tax (Receivable) (Tax Amount)
Purchases (Net Amount)
Payable (Gross Amount)
Subsequent payment of dues to the supplier will result in the following double
entry:
Debit
Credit
Payable (Gross Amount)
Cash/Bank (Gross Amount)
Example
Bike LTD purchases a mountain bike from BMX LTD for $115 on credit. Sales
tax is 15%.
As the purchase of $115 includes an element of sales tax, we need to first
separate tax from the gross amount. Input tax on the transaction may be
calculated as follows:
Sales Tax: 115 x 15/115 = $15
Deducting sales tax from the gross purchase, we may now arrive at the tax
exclusive purchase value:
Tax Exclusive Purchases: 115 - 15 = $100
This is the amount to be recognized as purchases in the income statement.
Payable will be recorded for the entire amount of $115 because sales tax on
purchases will also be paid to supplier. The accounting entry will therefore be
as follows:
Debit
Debit
Credit
Sales Tax (Receivable)
Purchases
BMX LTD (Payable)
$15
$100
$115
Upon payment of the amount payable to BMX LTD, following double entry will
be made:
Debit
Credit
BMX LTD (Payable)
Cash/Bank
$115
$115
The sales tax receivable of $15 will stand till it is recovered from tax
authorities.
Accounting for Loan Payable
Accounting for loan payables, such as bank loans, involves taking account of
receipt of loan, re-payment of loan principal and interest expense.
Receipt of Loan
Liability for loan is recognized once the amount is received from the lender.
Accounting entries for the receipt of loan are as follows:
Debit
Credit
Cash at Bank
Loan Payable
Loan payables need to be classified under current or non-current liabilities
depending on the maturity of loan re-payment. For example, if a loan is to be
repaid in 3 years' time, the liability would be recognized under non-current
liabilities. After 2 years, the liability will be re-classified under current liabilities,
i.e. when the loan is due to be settled within one year.
Where loan is to be repaid in several installments, the current and non-current
portions of the loan would need to be calculated using the loan repayment
schedule (see example).
Interest Expense
Interest expense is calculated on the outstanding amount of loan during that
period, i.e. the unpaid principal amount outstanding during the period. The
outstanding amount of loan could change due to receipt of another loan
installment or repayment of loan. Interest calculation needs to account for the
changes in outstanding amount of loan during a period (see example).
Accounting entry for recording interest accrued is as follows:
Debit
Credit
Finance Cost
Interest Payable
Upon payment of interest, following accounting entry will be recorded:
Debit
Credit
Interest Payable
Cash at Bank
Interest may be fixed for the entire period of loan or it may be variable.
Floating interest, also known as variable interest, varies over the duration of
the loan usually on the basis of an inter-bank borrowing rate such as LIBOR.
Fixed interest rate does not vary over time but is more expensive than a
floating interest rate.
Repayment of Loan
Repayments reduce the amount of loan payables recognized in financial
statements.
Following accounting entry is used to account for the repayment of loan:
Debit
Credit
Loan Payable
Cash at Bank
Example
ABC PLC received a bank loan of $100,000 on 1 January 20X1.
Terms of the loan agreement are as follows:

Loan is re-payable in 2 installments of $50,000 each on 30 June 20X2
and 30 June 20X3.

Interest is payable six-monthly in arrears at 5% plus LIBOR.

For the purpose of calculating interest, 6-month LIBOR at the start of
each 6 month period will be used.
6-month LIBOR rates over the period of the loan were as follows:
1 January 20X1
7%
1 July 20X1
8%
1 January 20X2
9%
1 July 20X2
8%
1 January 20X3
10%
Assuming all liabilities were settled on the due date, calculate:
a. Interest expense to be recognized in the income statements for the
years ended 30 June 20X1, 30 June 20X2 and 30 June 20X3.
b. Loan payables to be recognized in the balance sheets as at 30 June
20X1, 30 June 20X2 and 30 June 20X3.
Solution
Income Statement for the year ended (Extracts)
Finance Cost (Working 2)
30 June 20X1
30 June 20X2
30 June 20X3
6,000
13,500
7,000
Statement of Financial Position as at (Extracts)
30 June 20X1
30 June 20X2
30 June 20X3
Non-Current Liabilities
Bank Loan (Working 3)
50,000
-
-
50,000
50,000
-
Current Liabilities
Bank Loan (Working 3)
Working 1: Interest Rate
Period
LIBOR
Spread
Interest Rate
A
B
A+B
1 January 20X1 - 30 June 20X1
7%
5%
12%
1 July 20X1 - 31 December 20X1
8%
5%
13%
1 January 20X2 - 30 June 20X2
9%
5%
14%
1 July 20X2 - 31 December 20X2
8%
5%
13%
1 January 20X3 - 30 June 20X3
10%
5%
15%
Working 2: Finance Cost
Loan Outstanding
A
Interest Rate
B
Finance Cost
(A x B) / 2 *
1 January 20X1 - 30 June 20X1
100,000
12%
6,000
1 July 20X1 - 31 December 20X1
100,000
13%
6,500
1 January 20X2 - 30 June 20X2
100,000
14%
7,000
Period
13,500
1 July 20X2 - 31 December 20X2
50,000
13%
3,250
1 January 20X3 - 30 June 20X3
50,000
15%
3,750
7,000
*Yearly interest payment has been divided by 2 to obtain the amount of half
yearly interest payment.
Working 3: Loan Payable
Loan Outstanding
A
Current
B
Non-Current
A-B
1 January 20X1
100,000
-
100,000
30 June 20X1
100,000
50,000
50,000
30 June 20X2
50,000
50,000
-
30 June 20X3
-
-
-
Period
Accounting for Dividends on Ordinary Share Capital
Accounting Treatment
Dividends on ordinary share capital constitute an apportionment of the profits
attributable to owners of the business and hence should not be charged as an
expense in the income statement. Instead, such dividends must be accounted
for as a deduction from the retained earnings presented in the statement of
changes in equity.
For accounting purposes, scrip dividends, also known as bonus issues, shall
not be considered as dividends since they do not involve the distribution of
any assets to the shareholders.
As articles of association of companies usually require dividend payments to
be made proportionate to the amount paid up on shares, the amount
recognized as dividends should be pro-rated to account for any shares that
are not yet fully paid.
Accounting Entries
Following accounting entries should be recognized for recording dividend
payable:
Debit
Credit
Retained Earnings
Dividend Payable
Upon the payment of dividend, following entries shall be recognized:
Debit
Credit
Credit
Dividend Payable
Bank
Withholding Tax Payable*
*Applicable where tax on dividend income is required to be deducted at
source by the companies issuing the dividend.
When to recognize dividend?
Dividend payable should be recognized when the issuance of dividend is
properly authorized.
Dividend is authorized for issue when:

Issuance of dividend is approved by the relevant authority (e.g.
shareholders) upon the recommendation of management in jurisdictions
that require such approval; or

Dividend is declared by the management (e.g. board of directors) in
jurisdictions that do not require any further approval.
In any case, no liability in respect of dividends shall be recognized where
dividends are declared after the end of the reporting period. If however such
dividends are declared before the authorization of financial statements, they
shall be disclosed in the notes in accordance with IAS 10 Events after the
Reporting Period.
Presentation & Disclosure
IAS 1 Presentation of Financial Statements requires the following in respect of
dividends:

Amount of dividends recognized (in total and per share) to be disclosed
in the statement of changes in equity or in the notes

Dividends declared after the end of the reporting period but before the
authorization of financial statements not recognized as dividends during
the period to be disclosed in the notes
IAS 1 prohibits presentation of the above information in the income statement.
IAS 7 Statement of Cash Flows allows presentation of dividends paid during
the period in either:

Cash flow from operating activities; or

Cash flow from financing activities.
Example
During the year ended 31 December 2013, ABC PLC paid the following
dividends:

Final dividend of last year amounting $2 per share (declared in the
previous accounting period)

Interim dividend of $1 per share
Final dividend for the current year was declared on 10 January 2014
amounting $2.5 per share. No interim dividend was declared in the previous
accounting period. Dividend payments made last year amounted $1,500,000
in respect of dividends declared in 2011.
ABC PLC has 1 million fully paid ordinary shares in issue of $1 each.
Payment of dividends is subject to withholding tax of 5%.
Following accounting entries will be recorded during the year ended 31
December 2013:
Final dividend - Payment •
Debit
Credit
Credit
Dividend Payable
Bank
Withholding Tax Payable
$2,000,000 (1 million shares x $2)
$1,900,000 ($2,000,000 x 95%)
$100,000 ($2,000,000 x 5%)
Interim dividend - Payable •
Debit
Credit
$1,000,000 (1 million shares x $1)
$1,000,000
Retained Earnings
Dividend Payable
Interim dividend - Payment •
Debit
Credit
Credit
$1,000,000 (1 million shares x $1)
$950,000 ($1,000,000 x 95%)
$50,000 ($1,000,000 x 5%)
Dividend Payable
Bank
Withholding Tax Payable
Information relating to dividends shall be presented in the statement of
changes in equity and statement of cash flows as follows:
ABC Plc
Statement of changes in equity for the
year ended 31st December 2012
Balance at 1 January 2012
Share
Capital
Retained
Earnings
Revaluation
Surplus
Total
Equity
USD
USD
USD
USD
1,000,000
5,000,000
-
2,500,000
(2,000,000)
1,000,000
5,500,000
-
3,000,000
(1,000,000)
1,000,000
7,500,000
1,000,000
3,00,000
Changes in equity for the year 2012
Profit for the year
Dividends - Final Dividend of $2 per share
Balance at 31 December 2012
1,000,000
2,500,000
(2,000,000)
3,500,000
Changes in equity for the year 2013
Profit for the year
Dividends
Balance at 31 December 2013
1,000,000
3,000,000
(1,000,000)
5,500,000
Statement of Cash Flows for the year ended 31st December 2013 (Extract)
2013
USD
Financing Activities
2012
USD
3,000,000
Dividends Paid *
1,500,000
* Dividend paid could also be presented in cash flow from operating activities.
The solution assumes withholding tax payable is settled in the same
accounting period.
The details of the final dividend of $2.5 per share declared after the end of the
reporting period shall be disclosed in the notes to financial statements.
Please note that the final dividend of last year is presented as a deduction
from the retained earnings of 2012 as it was declared in that period.
This article deals with cash dividends on equity shares. Accounting for
dividends involving transfer of non-monetary assets shall be covered in a
separate article.
Prepaid Expense
Prepaid expense is expense paid in advance but which has not yet been
incurred.
Expense must be recorded in the accounting period in which it is incurred.
Therefore, prepaid expense must be not be shown as expense in the
accounting period in which it is paid but instead it must be presented as such
in the subsequent accounting periods in which the services in respect of the
prepaid expense have been performed.
Entity should therefore recognize an asset in respect of expense it has paid in
advance until such time as the services that are due in relation to the prepaid
expense have been performed by the suppliers/contractors. Following
accounting entry is required to account for the prepaid expense:
Debit
Credit
Example
Prepaid Expense (Asset)
Cash/Bank
ABC LTD pays advance rent to its landowner of $10,000 on 31st December
2010 in respect of office rent for the following year. ABC LTD has an
accounting year end of 31st December 2010.
ABC LTD will recognize an asset of $10,000 in the financial statements of
year 2010 in respect of the prepaid expense to recognize its right to use office
space in the following year. Following accounting entry will be recorded in the
books of ABC LTD in the year 2010:
Debit
Credit
$10,000
$10,000
Prepaid Rent
Cash/Bank
The prepaid expense will be recognized as expense in the next accounting
period to which the rental expense relates. Following accounting entry will be
recorded in the year 2011:
Debit
Credit
Rent Expense (Income Statement)
Prepaid Rent
$10,000
$10,000
Test Your Understanding
XYZ LTD has a year end of 31st December 2011. Which of the following transactions should
lead to recognition of prepaid expense in the financial statements of XYZ LTD?
XYZ LTD paid rent in advance for one year on 1st November 2011.
XYZ LTD entered into an insurance contract for 12 months starting from 1st January 2012.
Payment was scheduled to be made in advance by no later than 25th December 2011.
However, the payment was actually made on 1st January 2012.
XYZ LTD paid DEF LTD, an advertising agency, on 1st December 2011 for advertising services
rendered in December 2011.
Accruals Basis of Accounting
Financial statements are prepared under the Accruals Basis of accounting
which requires that income and expense must be recognized in the
accounting periods to which they relate rather than on cash basis. An
exception to this general rule is the cash flow statement whose main purpose
is to present the cash flow effects of transaction during an accounting period.
Under accruals basis of accounting, an entity must account for the following
types of transactions:

Accrued Income

Accrued Expense

Prepaid Income

Prepaid Expense

Accrued Income




Accrued income is income which has been earned but not yet received.
Income must be recorded in the accounting period in which it is earned.
Therefore, accrued income must be recognized in the accounting period
in which it arises rather than in the subsequent period in which it will be
received.
As income will be credited to record the accrued income, a
corresponding receivable must be created to account for the debit side
of the transaction. The accounting entry to record accrued income will
therefore be as follows:
Debit
Credit
Income Receivable (Balance Sheet)
Income (Income Statement)

Example

ABC LTD receives interest of $10,000 on bank deposit for the month of
December 2010 on 3rd January 2011. ABC LTD has an accounting year
end of 31st December 2010.
ABC LTD will recognize interest income of $10,000 in the financial
statements of year 2010 even though it was received in the next
accounting period as it relates to the current period. Following

accounting entry will need to be recorded to account for the interest
income accrued:

Debit
Credit









$10,000
$10,000
On the date of receipt of interest (i.e. 3rd January of the next year)
following accounting entry will need to be recorded in the subsequent
year:
Debit
Credit

Interest Income Receivable
Interest on Bank Deposit (Income)
Bank
Interest Income Receivable
$10,000
$10,000
 Test Your Understanding
ABC LTD has a year end of 31st December 2011. Which of the following transactions
and events should result in the recognition of accrued income in ABC LTD's financial
statements?
ABC LTD receives rent income in advance. Rent for the first quarter of 2012 is due on 31st
December 2011.
ABC LTD receives interest on bank deposits on the 5th of the subsequent month. Interest on
bank deposit for the month of December 2011 was received on 5th January 2012.
ABC LTD sold inventory to a customer on 29th December 2011 on a one month credit
period.
Accrued Expense




Accrued expense is expense which has been incurred but not yet paid.
Expense must be recorded in the accounting period in which it is
incurred. Therefore, accrued expense must be recognized in the
accounting period in which it occurs rather than in the following period in
which it will be paid.
As expense will be debited to record the accrued expense, a
corresponding payable must be created to account for the credit side of
the transaction. The accounting entry to record accrued expense will
therefore be as follows:
Debit
Credit
Expense (Income Statement)
Expense Payable (Balance Sheet)

Example

ABC LTD pays loan interest for the month of December 2010 of
$10,000 on 3rd January 2011. ABC LTD has an accounting year end of
31st December 2010.
ABC LTD will recognize interest expense of $10,000 in the financial
statements of year 2010 even though it was paid in the next accounting
period as it relates to the current period. Following accounting entry will
need to be recorded to account for the interest expense accrued:


Debit
Credit









$10,000
$10,000
On the date of payment of interest (i.e. 3rd January of the next year)
following accounting entry will need to be recorded in the subsequent
year:
Debit
Credit

Interest Expense
Interest Payable
Interest Payable
Bank
$10,000
$10,000
 Test Your Understanding
ABC LTD has a year end of 31st December 2011. Which of the following transactions
and events should give rise to accrued expense in ABC LTD's financial statement?
ABC LTD receives rent income in advance. Rent for the first quarter of 2012 is due on 31st
December 2011.
ABC LTD pays salary to its employees on 25th of every month.
XYZ LTD provides janitorial services to ABC LTD. The related expense for the month of
December 2011 had not been recorded in the financial statements as the related invoice was
received in February 2012.
Prepaid Income



Prepaid income is revenue received in advance but which is not yet
earned.
Income must be recorded in the accounting period in which it is earned.
Therefore, prepaid income must be not be shown as income in the
accounting period in which it is received but instead it must be
presented as such in the subsequent accounting periods in which the

services or obligations in respect of the prepaid income have been
performed.
Entity should therefore recognize a liability in respect of income it has
received in advance until such time as the obligations or services that
are due on its part in relation to the prepaid income have been
performed. Following accounting entry is required to account for the
prepaid income:
Debit
Credit
Cash/Bank
Prepaid Income (Liability)

Example

ABC LTD receives advance rent from its tenant of $10,000 on 31st
December 2010 in respect of office rent for the following year. ABC LTD
has an accounting year end of 31st December 2010.
ABC LTD will recognize a liability of $10,000 in the financial statements
of year 2010 in respect of the prepaid income to acknowledge its
obligation to make the office space available to the tenant in the
following year. Following accounting entry will be recorded in the books
of ABC LTD in the year 2010:

Debit
Credit

Cash/Bank
Prepaid Rent Income (Liability)
$10,000
$10,000
The prepaid income will be recognized as income in the next accounting
period to which the rental income relates. Following accounting entry
will be recorded in the year 2011:
Debit
Credit
Prepaid Rent Income (Liability)
Rent Income (Income Statement)
$10,000
$10,000
Prepaid Expense
Prepaid expense is expense paid in advance but which has not yet been
incurred.
Expense must be recorded in the accounting period in which it is incurred.
Therefore, prepaid expense must be not be shown as expense in the
accounting period in which it is paid but instead it must be presented as such
in the subsequent accounting periods in which the services in respect of the
prepaid expense have been performed.
Entity should therefore recognize an asset in respect of expense it has paid in
advance until such time as the services that are due in relation to the prepaid
expense have been performed by the suppliers/contractors. Following
accounting entry is required to account for the prepaid expense:
Debit
Credit
Prepaid Expense (Asset)
Cash/Bank
Example
ABC LTD pays advance rent to its landowner of $10,000 on 31st December
2010 in respect of office rent for the following year. ABC LTD has an
accounting year end of 31st December 2010.
ABC LTD will recognize an asset of $10,000 in the financial statements of
year 2010 in respect of the prepaid expense to recognize its right to use office
space in the following year. Following accounting entry will be recorded in the
books of ABC LTD in the year 2010:
Debit
Credit
$10,000
$10,000
Prepaid Rent
Cash/Bank
The prepaid expense will be recognized as expense in the next accounting
period to which the rental expense relates. Following accounting entry will be
recorded in the year 2011:
Debit
Credit
Rent Expense (Income Statement)
Prepaid Rent
$10,000
$10,000
Test Your Understanding
XYZ LTD has a year end of 31st December 2011. Which of the following transactions should
lead to recognition of prepaid expense in the financial statements of XYZ LTD?
XYZ LTD paid rent in advance for one year on 1st November 2011.
XYZ LTD entered into an insurance contract for 12 months starting from 1st January 2012.
Payment was scheduled to be made in advance by no later than 25th December 2011.
However, the payment was actually made on 1st January 2012.
XYZ LTD paid DEF LTD, an advertising agency, on 1st December 2011 for advertising services
rendered
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