Accrual Basis, Estimates and Periods
Cash answers when; accrual answers what period
During December, Northstar:
| Event | Cash in December | December accrual effect |
|---|---|---|
| Receives £24,000 for maintenance from January to December next year | +24,000 | Contract liability +24,000; no service revenue yet |
| Uses electricity estimated at £3,200, billed in January | — | Expense +3,200; accrued liability +3,200 |
| Pays £12,000 for insurance covering December–November | −12,000 | December expense £1,000; prepayment £11,000 |
| Uses production equipment; monthly depreciation is £2,500 | — | Expense +2,500; accumulated depreciation +2,500 |
Together, these four events result in December cash flow of +£12,000 and a profit effect of −£6,700. Neither figure is “more true”: one records cash movements, while the other reflects the period's income and expenses.
The four common timing patterns
| Cash timing | Economic activity | Initial account | Later entry |
|---|---|---|---|
| Cash first, expense later | Prepayment | Asset | Dr expense; Cr prepayment |
| Expense first, cash later | Accrual | Liability | Settle liability when paid |
| Cash first, revenue later | Customer advance | Contract liability | Dr liability; Cr revenue |
| Revenue first, cash later | Credit sale | Receivable or contract asset | Collect or reclassify later |
Work from the required closing balance
For the £12,000 insurance payment above, assume the original entry was Dr Prepayment; Cr Cash. At 31 December, 11 of the 12 covered months remain, so the asset must be £11,000. The adjustment is the difference between the recorded £12,000 asset and that required balance:
| Stage | Entry | What it means |
|---|---|---|
| December payment | Dr Prepayment £12,000; Cr Cash £12,000 | Buy future cover |
| December adjustment | Dr Insurance expense £1,000; Cr Prepayment £1,000 | Recognise one month consumed |
| Following January | Dr Insurance expense £1,000; Cr Prepayment £1,000 | Consume the next month; no second payment |
If the payment had initially been recorded entirely as expense, the December adjustment would instead be Dr Prepayment £11,000; Cr Insurance expense £11,000. Both routes end with the same £1,000 expense and £11,000 asset. Always inspect the unadjusted account before choosing the adjustment amount.
For electricity, the expense comes before the payment: Dr Electricity expense £3,200; Cr Accrued expenses £3,200. If the January invoice matches the estimate, payment clears the liability without recording the December expense again. If the amount differs, investigate the estimate and the period it relates to before deciding how to record the difference.
Matching without the myth
Students often learn “match costs to revenue.” That is useful shorthand, but it is not permission to create an asset merely to smooth profit. Under the Conceptual Framework, expense recognition follows changes in assets and liabilities.
Example:
- Cost of a delivered bike leaves inventory and becomes cost of sales because the inventory resource is consumed.
- An advertising campaign is not carried forward merely because managers expect future sales; it must satisfy the relevant asset requirements.
Estimates are part of accrual accounting
Calculating depreciation, expected credit losses, warranty provisions and net realisable value requires estimates. To make an estimate that others can assess, state:
- the measurement objective;
- the evidence available at the reporting date;
- the method and assumptions;
- sensitivity to reasonable alternatives;
- what changed since the prior estimate.
A new estimate based on new information is normally applied prospectively. Correcting a prior error is a different issue.
Period-end checklist
Ask whether Northstar has:
- delivered goods or services not yet invoiced;
- received goods or services not yet billed;
- paid or received cash for future periods;
- consumed long-lived assets;
- experienced loss indicators or changed estimates;
- omitted cut-off items near the reporting date.
Quick check
Northstar pays £36,000 on 1 October for 12 months of rent. What appears at 31 December?