make adjustments for accrued and prepaid expenses and accrued and prepaid income

Topic 5.1 – Sole Traders (Year‑End Adjustments)

1. Foundations of Accounting

• Purpose of accounting: to provide reliable, comparable information about a business’s performance and financial position for users (owner, lenders, tax authorities, etc.).
• Accounting equation (statement of financial position):

  
  Assets = Liabilities + Owner’s Capital

• Profit‑and‑Loss account (income statement) shows the results of operations for a period; the net profit (or loss) is transferred to the capital account.
• Double‑entry bookkeeping: every transaction affects at least two accounts – one debit and one credit – keeping the accounting equation in balance.

2. Sources of Data & Books of Prime Entry

Transactions are first recorded in source documents and then entered into the appropriate book of prime entry before posting to the ledger.

Posting example (sales journal to sales ledger)

Sales journal entry (31 Mar):
Date      Account          Debit   Credit
31 Mar    Debtors – ABC    1 200
Sales Revenue            1 200
Post to ledger:
Debtors – ABC      Dr 1 200
Sales Revenue      Cr 1 200

3. Verification of Accounting Records

3.1 Trial Balance

• Prepared after posting all ledger entries.
• Ensures total debits = total credits – a first check for arithmetic accuracy.
• Does not guarantee that all transactions are recorded correctly (e.g., omission errors).

3.2 Common errors that do NOT affect the trial balance

3.3 Bank Reconciliation (simplified)

Cash book balance (31 Dec)               £5 200
Add: Deposits not yet recorded
– Cheque received 31 Dec            £300
Less: Payments not yet cleared
– Cheque issued 30 Dec               £420
Adjusted cash‑book balance               £5 080
Bank statement balance (31 Dec)          £5 080
Reconciled – both balances agree.

3.4 Control Accounts (example: Purchases Ledger Control)

The control account summarises the total of all individual creditor balances.

Purchases Ledger Control – Creditors
Opening balance                Dr 0      Cr 2 500
Purchases (Jan‑Dec)            Dr 12 000
Payments to creditors          Cr 9 800
Closing balance                Dr 0      Cr 4 700

Individual creditor totals in the purchases ledger must equal £4 700.

4. Accounting Procedures (Capital vs. Revenue, Depreciation, Accruals, Doubtful Debts, Inventory)

4.1 Capital vs. Revenue Items

Capital items create or enhance an asset and are recorded on the balance sheet; revenue items relate to the period’s profit and loss.

4.2 Depreciation of Non‑Current Assets

Depreciation allocates the cost of a capital asset over its useful life.

4.3 Accrued & Prepaid Items (Expenses and Income)

• Accrued expense: incurred but not yet paid – recognised as an expense and a current liability.
• Prepaid expense: paid in advance – initially recorded as an asset; the portion used up is transferred to expense.
• Accrued income: earned but not yet received – recognised as revenue and a current asset.
• Prepaid (unearned) income: cash received before the service is performed – recorded as a liability; the earned portion is transferred to revenue.

4.4 Provision for Doubtful Debts

Estimates the amount of trade receivables that may become irrecoverable.

• Calculated as a % of total trade receivables (or using an ageing analysis).
• Recorded as an expense and a contra‑asset (reduces the net realizable value of receivables).

4.5 Inventory Valuation

Closing stock is valued at the lower of cost or net realisable value and transferred to the profit‑and‑loss account as “Closing stock”.

• Cost can be determined by FIFO, weighted‑average or specific identification (IGCSE expects the weighted‑average method for most questions).
• Closing stock reduces the cost of goods sold, thereby increasing profit.

5. Year‑End Adjustments for a Sole Trader

5.1 Overview of the Adjustment Process

1. Post all transactions to the ledger.
2. Prepare an unadjusted trial balance.
3. Identify required year‑end adjustments (accrued/prepaid items, depreciation, bad debts, provision, drawings, closing stock).
4. Record each adjustment as a journal entry and post to the ledger.
5. Prepare an adjusted trial balance.
6. Transfer totals to the profit‑and‑loss account, calculate net profit (or loss).
7. Determine closing capital:
   Closing capital = Opening capital + Net profit – Drawings.
8. Prepare the final Statement of Financial Position.
9. Close temporary accounts to the capital account.

5.2 Adjustment Tables

Accrued & Prepaid Expenses

Accrued & Prepaid Income

Depreciation

Irrecoverable Debts (Bad Debts)

Provision for Doubtful Debts

Drawings of Stock

Closing Inventory

5.3 Summary of All Adjustments

6. Worked Examples (All Adjustments)

Example 1 – Accrued electricity expense

Electricity bill for May = £480. Payment due 10 June.

31 May   Electricity expense          480
Accrued liabilities – electricity          480

Example 2 – Prepaid insurance (monthly charge)

12‑month premium £1 200 paid 1 Jan. Monthly charge = £100.

31 Jan   Insurance expense            100
Prepaid insurance                         100

Remaining prepaid insurance = £1 100.

Example 3 – Accrued service revenue

Services performed 28 May worth £750; cash to be received 5 June.

31 May   Accrued receivables – services   750
Service revenue                               750

Example 4 – Prepaid rent (unearned income)

Rent £1 800 received 1 June for June – July. Monthly rent = £900.

30 Jun   Unearned rent income          900
Rent income                                 900

Example 5 – Depreciation (straight‑line) of a motor vehicle

Cost £6 000, useful life 5 years, no residual value.

31 Dec   Depreciation expense          1 200
Accumulated depreciation – vehicle          1 200

Example 6 – Depreciation (reducing‑balance) of equipment

Cost £5 000, depreciation rate 20 %.

31 Dec   Depreciation expense          1 000   (20 % of £5 000)
Accumulated depreciation – equipment          1 000

Example 7 – Bad debt written off

Trade receivable £320 deemed irrecoverable.

31 Dec   Bad‑debt expense               320
Trade receivables                               320

Example 8 – Provision for doubtful debts

Trade receivables £4 000; estimated 5 % doubtful.

31 Dec   Provision for doubtful debts   200
Provision for doubtful debts (contra‑asset)   200

Example 9 – Drawings of stock

Owner takes £250 of stock for personal use.

31 Dec   Drawings – stock               250
Stock                                            250

Example 10 – Closing inventory

Opening stock £2 000, purchases £5 000, closing stock counted £1 800.

31 Dec   Closing stock                 1 800
Cost of goods sold                                 1 800

Cost of goods sold = Opening stock + Purchases – Closing stock = £5 200.

7. Preparing the Final Financial Statements

7.1 Adjusted Trial Balance (sample layout)

7.2 Profit‑and‑Loss Account (extract)

Revenue
Sales revenue                         12 000
Service revenue                         750
Rent income                             900
Total revenue                               13 650
Less: Expenses
Electricity expense          480
Insurance expense            100
Depreciation expense        1 200
Bad‑debt expense             320
Provision for doubtful debts 200
Cost of goods sold          5 200
Total expenses                               7 500
Net profit                                   6 150

7.3 Statement of Financial Position (extract)

8. Key Points to Remember for the IGCSE Exam

• Always check the matching principle – recognise revenue and the expenses that generated it in the same period.
• Distinguish capital (balance‑sheet) from revenue (profit‑and‑loss) items; mis‑classifying a capital expense as revenue will under‑state profit.
• Accrued items are recorded before cash changes hands; prepaid items are recorded as assets (or liabilities) and only moved to expense/revenue when the period to which they relate has elapsed.
• Depreciation can be calculated by straight‑line or reducing‑balance; use the method specified in the question.
• When preparing the trial balance, remember that it only tests arithmetic – always review the ledger for possible omissions, commissions or compensating errors.
• Closing stock reduces the cost of goods sold; an incorrect stock figure will distort profit.
• Net profit is transferred to the capital account; drawings reduce capital but do not affect the profit‑and‑loss figure.
• For a sole trader, the statement of financial position will contain only current liabilities and owner’s capital – non‑current liabilities are rare.