Contents: 8 sections
Cambridge IGCSE Accounting 0452 · Core and Extended
Syllabus points
- Explain the matching principle as it applies to expenses and income.
- Adjust expense and income accounts for amounts accrued and prepaid.
- Show accrued and prepaid amounts in the statement of financial position.
The idea
The income statement must show the expenses incurred in the year and the income earned in the year, whatever was actually paid or received. That is the matching principle, and every adjustment in this topic comes from it.
The old names still appear in questions. Accrued expenses are also called other payables; prepaid expenses are also called other receivables.
The four cases
| Item | Meaning | Income statement | Statement of financial position |
|---|---|---|---|
| Accrued expense | Used, not yet paid | Add to the expense | Current liability (other payable) |
| Prepaid expense | Paid, belongs to next year | Deduct from the expense | Current asset (other receivable) |
| Accrued income | Earned, not yet received | Add to the income | Current asset |
| Prepaid income | Received, not yet earned | Deduct from the income | Current liability |
The pattern behind all four: anything the business owes, or has been paid for and not yet earned, is a liability. Anything the business is owed, or has paid ahead for, is an asset.
Working it through the account
Learning the signs is fragile. Working it through the expense account is reliable, and it also handles the case where there are opening and closing adjustments.
Rent for the year: $1 200 was owing at the start, $15 600 was paid during the year, and $900 is owing at the end.
The expense for the year is the amount paid, less the $1 200 that belonged to last year, plus the $900 that belongs to this year but has not been paid. That is 15 600 minus 1 200 plus 900, which is $15 300.
In the ledger the same thing looks like this. The rent account opens with a credit balance b/d of $1 200 (an accrual is owed, so it is a liability). Payments of $15 600 are debited. The closing accrual of $900 is entered as a credit balance c/d. The transfer to the income statement is the balancing figure, $15 300.
A prepayment works the mirror image: it opens as a debit balance b/d, because it is an asset.
Income as well as expenses
The same treatment applies to income the business receives, such as rent received or commission received.
Rent received of $4 800 was banked during the year. At the start of the year a tenant owed $400, and at the end of the year a tenant has paid $600 in advance.
The income for the year is 4 800 less the 400 earned last year, less the 600 that belongs to next year, which is $3 800. The $600 received in advance is a current liability, because the business owes the tenant use of the property it has not yet provided.
Prepaid income being a liability is counter-intuitive and is often marked wrong. Money received for something not yet delivered is an obligation, not an asset.
In the statement of financial position
- Other receivables (prepaid expenses and accrued income) go among current assets, usually next to trade receivables.
- Other payables (accrued expenses and prepaid income) go among current liabilities, next to trade payables.
Both are current, because they will be settled within a year.
Why it matters
Leaving an accrual out understates the expense, so profit is overstated and a liability is missing. Leaving a prepayment out overstates the expense, so profit is understated and an asset is missing. Either way both statements are wrong, and the error reverses itself next year, which makes two years' figures wrong rather than one.
Common mistakes
- Reversing the treatment: adding a prepayment to the expense instead of deducting it.
- Putting prepaid expenses among current liabilities.
- Treating income received in advance as an asset.
- Adjusting the income statement and forgetting the statement of financial position, or the reverse.
- Ignoring the opening accrual or prepayment and adjusting only for the closing one.
- Using the amount paid as the expense when the question clearly gives adjustments.