How do you adjust expenses and income for accruals and prepayments at the year end, and how are bad debts treated?
Adjusting the income statement and statement of financial position for accrued and prepaid expenses and income at the year end, and writing off bad debts (irrecoverable debts).
A focused answer to the SQA National 5 Accounting content on year-end adjustments, covering accrued and prepaid expenses, accrued and prepaid income, how each adjusts the figure in the income statement and appears in the statement of financial position, and the writing off of bad (irrecoverable) debts.
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What this dot point is asking
The SQA wants you to adjust expenses and income at the year end for accruals (amounts owing) and prepayments (amounts paid in advance), show the adjusted figure in the income statement and the balance in the statement of financial position, and write off bad debts.
Why adjustments are needed
A business pays and receives cash at times that do not match the financial year exactly. It might pay next year's rent early, or still owe this year's electricity. The matching (accruals) concept says profit should compare the income earned with the expenses incurred in the same period, regardless of when the cash moved. Year-end adjustments correct the raw cash figures.
Accrued expenses
An accrued expense is one the business has used but not yet paid - for example electricity used in December but billed in January. Add it to the expense and show it as a current liability.
Prepaid expenses
A prepaid expense is one paid in advance for a future period - for example rent paid for the first month of next year. Deduct it from the expense and show it as a current asset.
Accrued and prepaid income
The same idea applies to income the business earns, such as rent received.
- Accrued income is income earned but not yet received (for example rent owed to the business at the year end). Add it to the income and show it as a current asset.
- Prepaid income is income received in advance for next year. Deduct it from this year's income and show it as a current liability.
Bad debts
A bad debt (irrecoverable debt) is money owed by a credit customer who will never pay - because they have gone out of business, for instance. Write it off: charge it as a bad debts expense in the income statement and reduce trade receivables by the same amount in the statement of financial position.
Examples in context
At the year end a shop has used of electricity it has not been billed for and has paid of rates covering the first quarter of next year. The accountant adds the accrual to the electricity expense and lists it as a current liability, and deducts the prepayment from rates and lists it as a current asset. A debt from a closed-down customer is written off. Each adjustment makes the profit and the statement of financial position show the true position for the year - exactly what this dot point tests.
Try this
Q1. Rent paid , of which is prepaid. Find the income statement figure. [2 marks]
- Cue. .
Q2. Electricity paid , with still owing. Find the income statement figure. [2 marks]
- Cue. .
Q3. Where does a prepaid expense appear in the statement of financial position? [1 mark]
- Cue. As a current asset.
Exam-style practice questions
Practice questions written in the style of SQA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
SQA N5 style4 marksA business has paid 5000 pounds in rent during the year, but 500 pounds of this relates to next year. Insurance of 1200 pounds has been paid, but 200 pounds is still owing at the year end. Calculate the rent and insurance figures to show in the income statement and state how each adjustment appears in the statement of financial position.Show worked answer →
Rent is prepaid by , so the income statement shows (1 mark), and the prepayment is a current asset (prepaid expense) in the statement of financial position (1 mark). Insurance is accrued by , so the income statement shows (1 mark), and the accrual is a current liability (accrued expense) in the statement of financial position (1 mark). Markers reward deducting a prepayment, adding an accrual, and the correct classification as a current asset or current liability.
SQA N5 style3 marksA customer who owes 600 pounds has gone out of business and cannot pay. Explain how this bad debt is treated in the financial statements.Show worked answer →
The is a bad (irrecoverable) debt: the amount can no longer be collected, so it is written off (1 mark). It is recorded as a bad debts expense of in the income statement, reducing profit (1 mark), and the trade receivables in the statement of financial position are reduced by because that customer will never pay (1 mark). Markers reward identifying it as an expense in the income statement and a reduction of trade receivables.
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