recognise the importance of matching costs and revenues

4.3 Other Payables and Other Receivables

Learning Objective

Students will be able to recognise why costs and revenues must be matched when recording other payables and other receivables, prepare the required journal entries, post them to ledger accounts, adjust the trial balance and explain the impact on the profit‑and‑loss account and the statement of financial position.

1. Definition and Scope

• Other payables and other receivables are short‑term items that arise from non‑trading activities (e.g. interest, rent, dividends, insurance).
• They are not included in the main categories of trade payables/receivables, salaries, or tax, but they still affect profit and the balance‑sheet.

2. Types of Other Payables/Receivables

Note: Cambridge terminology uses “Unearned (deferred) income”. In exam answers “Other Income” may be used where appropriate.

3. Why Matching Matters

• The matching principle requires that expenses be recorded in the same accounting period as the revenues they help generate.
• When a cost is recorded too early or omitted, profit is distorted:
  • Omitted expense → profit overstated.
  • Expense recorded in a later period → profit understated for the current period.
• Similarly, revenue must be matched with the period in which it is earned; otherwise profit will be overstated (if unearned revenue is recognised too early) or understated (if accrued income is ignored).

4. Effect on the Financial Statements

After the adjusting entries:

• Profit‑and‑Loss Account (Income Statement) – the expense or revenue appears in the correct period, giving a true profit figure.
• Statement of Financial Position (Balance Sheet) – the related asset (pre‑paid expense, accrued income) or liability (accrued expense, unearned income) is shown in the current‑assets or current‑liabilities section.

5. Journal Entries – Matching Costs and Revenues

6. Ledger Posting – Example T‑accounts

Using the four entries above, the T‑accounts are shown below (figures are illustrative).

7. Trial Balance – Before and After Adjustments

Before adjusting entries (selected accounts only):

After posting the four adjusting entries:

The trial balance remains balanced, but now reflects the correct expense, revenue, asset and liability amounts.

8. Worked Examples

Example 1 – Accrued Interest Expense

Scenario: ABC Ltd borrowed $10 000 at 6 % per annum on 1 July. The financial year ends 31 December. No interest has been paid by year‑end.

1. Calculate the interest to be accrued:
   Interest Expense = 10 000 × 0.06 × 6/12 = $300
2. Journal entry:
   

   Interest Expense          300
         Interest Payable          300
           

3. Post to T‑accounts (see Section 6).
4. Effect: profit reduced by $300; current liability increased by $300.

Example 2 – Pre‑paid Insurance

Scenario: XYZ Ltd pays $600 on 1 January for a six‑month insurance policy covering January–June. The year‑end is 31 March.

1. Initial entry (payment in cash):
   

   Prepaid Insurance          600
         Cash                      600
           

2. Adjustment at 31 March (three months of insurance used):
   

   Insurance Expense          300
         Prepaid Insurance          300
           

3. Result: $300 of expense appears in the profit‑and‑loss account for the quarter, and $300 of prepaid insurance remains as an asset on the balance sheet.

9. Common Errors & How to Correct Them (AO3)

• Omission of an accrued expense – profit is overstated.
  Correction: Debit the appropriate expense and credit the related payable.
  AO3 link: Explain why the omission leads to an over‑statement of profit and how the adjustment restores accuracy.
• Recording a prepaid expense as an expense immediately – profit is understated and assets are understated.
  Correction: Debit the prepaid asset, credit cash; recognise expense gradually via adjusting entry.
  AO3 link: Discuss the effect on both the income statement and the balance sheet.
• Classifying unearned revenue as income – profit is overstated.
  Correction: Credit a liability (Unearned Revenue) and defer the income until earned.
  AO3 link: Evaluate the impact on profit measurement and on current liabilities.
• Mis‑classifying a receivable as a payable (or vice‑versa) – trial balance stays balanced but the balance‑sheet presentation is wrong.
  Correction: Reverse the incorrect entry and record the correct one.
  AO3 link: Explain why the classification matters for users of the financial statements.

10. Key Points to Remember

• Identify every non‑trading item that creates a payable or receivable.
• Determine whether it is an accrued expense, accrued income, pre‑paid expense or unearned (deferred) income.
• Make adjusting journal entries so that expenses and revenues are recorded in the same accounting period (matching principle).
• Post the entries to the appropriate ledger accounts and verify that the trial balance remains in balance.
• Check the profit‑and‑loss account – profit must reflect the matched costs and revenues.
• Check the statement of financial position – assets and liabilities must show the correct balances after adjustments.

11. Self‑Check Questions

1. Why must prepaid insurance be recorded as an asset initially?
2. What would happen to profit if accrued wages were omitted at year‑end?
3. Explain how “rent received in advance” affects the income statement for the period it is received and for the period it is earned.
4. Give an example of a common error when dealing with other receivables and show the correcting journal entry.
5. Briefly describe the impact on both the profit‑and‑loss account and the balance sheet of an accrued expense.