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.

Source document	Typical information recorded	Book of prime entry used
Invoice (sales)	Date, customer, amount, VAT	Sales journal
Invoice (purchases)	Date, supplier, amount, VAT	Purchases journal
Cash receipt (bank deposit, cash sales)	Date, amount, payer	Cash book (receipts side)
Cheque payment	Date, payee, amount	Cash book (payments side)
Credit note / debit note	Adjustments to previous invoices	General journal

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

Error type	Why the trial balance still balances
Omission of a transaction	Both debit and credit are missing.
Commission error (same amount on wrong side)	Debit recorded as a credit and vice‑versa.
Compensating error	Two errors of equal amount in opposite directions.

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.

Question to ask	Result
Does the item give future economic benefit beyond the current period?	Capital (asset)
Is the item consumed wholly within the accounting period?	Revenue (expense or income)

4.2 Depreciation of Non‑Current Assets

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

Method	Formula	Journal entry (annual)
Straight‑line	Depreciation = (Cost – Residual value) ÷ Useful life	Depreciation expense Dr  Accumulated depreciation Cr
Reducing‑balance (written‑down)	Depreciation = Book value at start of year × Depreciation rate	Depreciation expense Dr  Accumulated depreciation Cr
Revaluation (increase only)	Increase = New fair value – Carrying amount	Revaluation surplus Cr  Asset account Dr

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

Adjustment	Debit	Credit	Effect on profit
Accrued expense	Expense account	Accrued liabilities (or Trade payables)	↓ profit
Prepaid expense (portion used)	Expense account	Prepaid expense (asset)	↓ profit

Accrued & Prepaid Income

Adjustment	Debit	Credit	Effect on profit
Accrued income	Accrued receivables (asset)	Revenue account	↑ profit
Prepaid income (portion earned)	Unearned income (liability)	Revenue account	↑ profit

Depreciation

Method	Journal entry (annual)
Straight‑line	Depreciation expense Dr  Accumulated depreciation Cr
Reducing‑balance	Depreciation expense Dr  Accumulated depreciation Cr

Irrecoverable Debts (Bad Debts)

Journal entry	Debit	Credit
Bad‑debt expense	Bad‑debt expense	Trade receivables

Provision for Doubtful Debts

Journal entry	Debit	Credit
Provision for doubtful debts	Provision for doubtful debts (expense)	Provision for doubtful debts (contra‑asset)

Drawings of Stock

Journal entry	Debit	Credit
Drawings – stock	Drawings	Stock (or Purchases if not yet recorded)

Closing Inventory

Journal entry	Debit	Credit
Closing stock	Closing stock (asset)	Cost of goods sold

5.3 Summary of All Adjustments

Adjustment	Debit account	Credit account	Effect on profit
Accrued expense	Expense	Accrued liability	↓ profit
Prepaid expense (used)	Expense	Prepaid expense	↓ profit
Accrued income	Accrued receivable	Revenue	↑ profit
Prepaid income (earned)	Unearned income	Revenue	↑ profit
Depreciation (any method)	Depreciation expense	Accumulated depreciation	↓ profit
Bad‑debt expense	Bad‑debt expense	Trade receivables	↓ profit
Provision for doubtful debts	Provision for doubtful debts (expense)	Provision for doubtful debts (contra‑asset)	↓ profit
Drawings of stock	Drawings	Stock (or Purchases)	No direct effect on profit (reduces capital)
Closing inventory	Closing stock	Cost of goods sold	↑ profit (by reducing COGS)

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)

Account	Debit (£)	Credit (£)
Cash	3 200
Bank	2 500
Trade receivables	4 000
Accrued receivables	750
Prepaid insurance	1 100
Motor vehicle (cost)	6 000
Accumulated depreciation – vehicle		1 200
Stock (closing)	1 800
Trade payables		2 300
Accrued liabilities – electricity		480
Unearned rent income		900
Provision for doubtful debts		200
Capital – opening		5 000
Drawings	250
Sales revenue		12 000
Service revenue		750
Rent income		900
Electricity expense	480
Insurance expense	100
Depreciation expense	1 200
Bad‑debt expense	320
Provision for doubtful debts (expense)	200
Cost of goods sold	5 200
Total	25 500	25 500

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)

Assets	£	Liabilities & Capital	£
Current assets		Current liabilities
Cash	3 200	Trade payables	2 300
Bank	2 500	Accrued liabilities – electricity	480
Trade receivables	4 000	Unearned rent income	900
Accrued receivables	750
Prepaid insurance	1 100
Closing stock	1 800
Non‑current assets		Owner’s capital
Motor vehicle (cost)	6 000	Opening capital	5 000
Less: Accumulated depreciation	(1 200)	Add: Net profit	6 150
		Less: Drawings	(250)
		Closing capital	10 900
Total assets	25 500	Total liabilities & capital	25 500

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.