Year-end adjustments: accrued and prepaid amounts

Cash timing is not the same as earning timing

During the year the records follow the cash: an entry is made when money is paid or received. At year-end that is not good enough. The financial statements must report the expenses that belong to this year and the income that was earned in this year, whether or not the money moved.

That is the whole idea behind year-end adjustments. Nothing new happens in the business on the last day of the year. You are correcting the timing of things that already happened.

Four situations come up:

Read the middle column, not the labels. Every one of these is a question about which year the event really belongs to.

Two adjustments end to end

Worked example. Bongani's Barbers has a financial year ending 28 February.

Rent, an accrued expense. The Rent expense account shows R49 500, which the bookkeeper confirms covers only 11 months. The rent did not change during the year, so one month is missing.

1. Monthly rent = 49 500 / 11 = R4 500
2. February's rent has been used but not paid, so it belongs to this year: add R4 500 to the expense and record R4 500 as owing.
3. Rent expense in the income statement = 49 500 + 4 500 = R54 000. Accrued expenses of R4 500 appear as a current liability.

Insurance, a prepaid expense. On 1 November the business paid R7 200 for a 12-month policy.

1. Monthly cost = 7 200 / 12 = R600
2. Months used by 28 February: November, December, January, February = 4 months = R2 400
3. Months still to come = 8 months = R4 800, which belongs to next year. Remove it from the expense and show it as a current asset.
4. Insurance in the income statement = R2 400, with R4 800 shown as a prepaid expense.

The test that always works

For any adjustment, ask two questions in this order. First: how much of this belongs to the year that is ending? That number goes to the income statement. Second: is the leftover something the business now owes or something it is owed? Owes means liability, owed means asset. You never have to memorise a list if you can answer those two questions.

Core checkpoint: you can split an amount between the current and the next financial year, adjust the expense or income to the correct figure, and say correctly whether the leftover is an asset or a liability.