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Prepayments spread over the months they cover, costs used but not yet billed, deposits and unpaid invoices moved to the month the work is done, and each transaction recorded on two lines so the balance sheet still balances.
Paper packet. Every task here also exists on screen, where it is checked automatically; answers written on paper are not assessed by Nydus. When you are back at a device, enter your answers there.
You will spread a payment over the months it covers, count a cost used before its bill arrives, move deposits and unpaid invoices to the month the work was done, and record transactions on two lines so the balance sheet still balances.
You can keep a cash book and reconcile it, and you have read an income statement and a balance sheet. You know a profitable month can end with less cash. This lesson shows how the income statement is built from records of money that moved in other months, and why the balance sheet always balances.
| Term | What it means |
|---|---|
| Accruals basis | Counting revenue when the work is done and costs when they are used, not when money moves. |
| Prepayment | A cost paid before the months it covers; an asset until they arrive. |
| Accrued cost | A cost already used but not yet billed or paid; a liability until it is. |
| Deferred income | Money received for work not yet done, such as a deposit; a liability until the work is done. |
| Double entry | Recording every transaction on two lines, so the records always balance. |
| Debit and credit | The two sides of every entry: the left side and the right side of each account. |
Alexa pays Corner Bean's insurance for the year, 1200 dollars, on the 1st of January. On a cash basis January carries a cost of 1200 and the other eleven months carry nothing, so January looks terrible and February looks better than it is. Neither month is described truly.
On the accruals basis each month carries the cover it used: 1200 ÷ 12 = 100 a month. At the end of January 1100 is still prepaid — paid for months that have not yet happened — and sits on the balance sheet as something the café owns. Each month moves another 100 from the balance sheet to the income statement.
The opposite happens with a bill paid late. The café's electricity is billed each quarter in arrears. March used its share of the power, about 150 dollars, and the bill arrives in April. On the accruals basis March still carries the 150, as an accrued cost, and the balance sheet shows 150 owed.
Revenue follows the same rule. A catering deposit received in March for an April event is not March's revenue; it is deferred income, owed back if the event is canceled. An invoice sent for March's work and paid in April is March's revenue.
| Item | Cash moves | Month it counts |
|---|---|---|
| Year's insurance, 1200 | January | 100 each month |
| Quarter's electricity | April | 150 in each of January to March |
| Deposit for April's event | March | April |
| Invoice for March's work | April | March |
Another way: steps
Start from the cash book. The reconciled cash book says what moved in the month.
Revenue: take out and add in. Take out receipts for other months' work — last month's invoices paid late, deposits for next month. Add invoices for this month's work that are not yet paid.
Costs: spread and accrue. Spread any payment that covers several months — insurance, a license, rent paid a quarter ahead — over those months. Add any cost used this month whose bill has not arrived: power, water, a supplier's delivery invoiced late, staff hours worked in the last days of the month and paid next month.
Record the other side. Every adjustment leaves something on the balance sheet: prepaid cover is owned, an accrued bill is owed, a deposit is owed, an unpaid invoice is owed to the business.
To check: each adjustment should reverse in the month the money moves. When the electricity bill arrives in April, the 450 paid clears the 450 accrued over January to March and nothing lands in April's profit. If an adjustment never reverses, it was made in error.
Every transaction changes two lines, and the two changes always keep one equation true:
$$\text{what the business owns} = \text{what it owes} + \text{what the owner has in it}$$
Tomasz puts in 5000 of savings: cash up 5000, owner's equity up 5000. A bank lends 3000: cash up 3000, loan owed up 3000. A polytunnel is bought for 4200 cash: polytunnel up 4200, cash down 4200 — one thing owned swapped for another. Seed worth 300 on credit: stock up 300, owed to the supplier up 300. Each step keeps both sides equal.
A sale works the same way. Salad sold for 500 cash raises cash by 500 and, because the business is now worth 500 more to its owner, raises equity by 500 through the profit. Costs lower equity the same way. That is the link between the two statements: the income statement explains how the owner's equity changed over the month.
Bookkeepers write the two sides of each entry in two columns, debit on the left and credit on the right, and every entry has equal debits and credits. The names are only labels for the two sides. The rule that makes them work is short:
| Kind of line | Increased by | Decreased by |
|---|---|---|
| Assets and costs | Debit | Credit |
| Liabilities, equity and revenue | Credit | Debit |
So the bank's loan is a debit to cash, which rises, and a credit to the loan, which rises too. Paying the seed supplier is a debit to the supplier's account, which falls, and a credit to cash, which falls. A sale for cash is a debit to cash and a credit to revenue. Because every entry's debits equal its credits, the totals of all debits and all credits in the books must be equal; a trial balance lists them to check, and one that does not balance means an entry was made on one side only.
Most small businesses never write a debit by hand: accounting software makes both sides from one entry. Knowing the rule still explains what the software is doing, and why a payment coded to the wrong line moves two figures, not one.
The same rule decides how stock reaches the income statement. Flour bought in March and still in the store on the 31st has not been used, so it is not March's cost; it is an asset, like prepaid insurance, waiting for the month it is baked and sold. March's cost of sales is the stock that was used:
$$\text{cost of sales} = \text{opening stock} + \text{purchases} - \text{closing stock}$$
Corner Bean opened March with 600 of beans, milk and food, bought 2900 during the month, and counted 700 on the shelves on the 31st. Its cost of sales for March is 600 + 2900 − 700 = 2800, not the 2900 it paid for.
This is why a month-end stock count matters even to a small café. Without it, a month that stocked up for a busy weekend looks expensive and the following month looks cheap, and the margin the monthly review watches moves for no reason at all. With it, each month's margin describes the coffee and food that month actually sold. A rough count is far better than none: the error from counting the shelves quickly is small; the error from not counting them at all is the whole change in stock. The count also finds waste and theft, which show up as stock that was bought, never sold, and is no longer there.
Some tax systems let the smallest businesses work out their taxable profit on a cash basis, counting money when it moves, because it is simpler to keep. Whether a business may, and above what size it may not, is set by the tax authority and published on its website; it changes from country to country and from time to time.
Even a business allowed to use the cash basis for tax can run its own monthly figures on accruals, and most should, because the question the owner is asking — did this month's work make money? — is an accruals question. A month that happened to pay a year's insurance, or that received a large deposit for next month, answers it wrongly on a cash basis.
A wedding caterer takes a 30 percent deposit when a couple books, often a year ahead, and the balance a month before the wedding. One spring her cash book showed 42,000 received from January to April and only 18,000 spent, and she began to plan a new van.
Her bookkeeper redid the four months on the accruals basis. Of the 42,000, 27,000 was deposits and balances for weddings between May and September: deferred income, owed back if a wedding was canceled, and not yet earned. Only 15,000 was for events that had actually happened. On the cost side, the 18,000 included 4,800 of a year's insurance and licenses paid in January, of which 3,200 covered May onwards, so the four months' costs were 18,000 − 3,200 = 14,800. But food for two April events had been delivered and not yet invoiced: another 1,100 accrued, making 15,900.
So the four months had earned 15,000 and used 15,900: a small loss, in a season that is always quiet, carried by money that belonged to the summer. The van was bought in October, after the summer's weddings had turned the deposits into revenue, and the caterer began keeping deposits in a separate account so that they could not be mistaken for profit again.
Company accounts in most countries must be prepared on the accruals basis, because a statement that followed only the cash would let a business look healthy in the months it collected deposits and sick in the months it paid annual bills. The rule makes one month comparable with the next.
A cost belongs to the month it is paid. It belongs to the month it is used.
A deposit is revenue. It is owed back until the work is done.
No bill, no cost. Power used in March is March's cost when the bill arrives in April.
Buying equipment for cash makes the business poorer. It swaps one thing owned for another; its cost reaches the income statement over the years it is used.
Debit means bad and credit means good. They are only the two sides.
Spread the premium.
$1200 \div 12 = 100$
Each month's cost.
Count January's cost.
$100$
One month of cover used.
Find what is prepaid at the end of January.
$1200 - 100 = 1100$
Eleven months still to come.
Find what is prepaid at the end of March.
$1200 - 3 \times 100 = 900$
Nine months still to come.
Check at the year's end.
$1200 - 12 \times 100 = 0$
The whole premium has become cost.
Start from the money received.
$8200$
From the reconciled cash book.
Take out April's deposit.
$8200 - 400 = 7800$
Work not yet done.
Take out February's invoice paid late.
$7800 - 600 = 7200$
February's revenue.
Add March's unpaid invoices.
$7200 + 900 = 8100$
March's work, not yet paid.
Accrue March's electricity.
$150 \text{ owed}$
Used in March, billed in April.
Read March's revenue.
$8100 \text{ against } 8200 \text{ received}$
Close, but for different reasons in each line.
Record Tomasz's savings.
$\text{cash } +5000; \quad \text{equity } +5000$
Both sides up.
Record the bank's loan.
$\text{cash } +3000; \quad \text{loan } +3000$
Owned and owed up together.
Record the polytunnel bought for cash.
$\text{polytunnel } +4200; \quad \text{cash } -4200$
One asset swapped for another.
Record seed bought on credit.
$\text{stock } +300; \quad \text{supplier } +300$
Owned and owed up together.
Record salad sold for cash.
$\text{cash } +500; \quad \text{equity } +500$
Through the week's profit.
Total what is owned.
$4300 + 4200 + 300 = 8800$
Cash, polytunnel and seed.
Check against owed plus equity.
$3300 + 5500 = 8800$
The balance sheet balances.
Spread the rent.
$1800 \div 3 = 600$
Each month's cost.
Find what is prepaid at the end of April.
$1800 - 600 = 1200$
Two months to come.
Find what is prepaid at the end of June.
Corner Bean pays its insurance for the whole year, $1800$ dollars, on the 1st of January. Fill in how the payment is counted, in dollars.
| Amount | |
|---|---|
| Cost each month | |
| Cost counted by the end of March | |
| Still prepaid at the end of March | |
| Still prepaid at the end of June |
Complete the worked solution: a bakery paid $840$ dollars for a year's insurance on the 1st of January, and used about $160$ of gas in March that will be billed in April. Before either, March's profit is $2900$. Put both costs in March.
Divide the premium by twelve.
$840 \div 12 =$ s
March's share of the cover.
Count what is still prepaid at the end of March.
$9 \times (\text{share}) =$ r
Nine months still to come.
Take both of March's costs off the profit.
$2900 - (\text{share}) - 160 =$ n
Insurance used and gas used, whenever paid.
Record the gas as owed.
$160 \text{ accrued}$
A liability until the bill is paid.
Record the prepaid cover as owned.
$\text{prepaid on the balance sheet}$
An asset until its months are used.
Fixit Mobile's electricity is billed each quarter, in arrears. Dan expects the January-to-March bill to be about $270$ dollars, spread evenly, but it will not arrive until April. Before allowing for any electricity, March's profit comes to $3600$. What is March's profit once March's electricity is counted, in dollars?
Answer:
Five things that happened at Long Row Gardens. Match each to the two lines it changes.
| Cash up; loan owed up | Cash up; owner's equity up | Stock up; owed to suppliers up | Cash down; owed to suppliers down | Cash up; owed by customers down | |
|---|---|---|---|---|---|
| A bank lends $500$ | |||||
| Tomasz puts $500$ of his own savings in | |||||
| Seed worth $500$ is bought on thirty days' credit | |||||
| The seed supplier is paid | |||||
| A restaurant pays last month's invoice |
A new florist starts with the owner paying in $6000$ dollars. In the first week a bank lends $2100$, a cold room is bought for $2900$ cash, and flowers worth $600$ are bought on credit. Fill in the balance sheet at the end of the week, in dollars.
| Amount | |
|---|---|
| Cash at the end of the week | |
| Total assets | |
| Total liabilities | |
| Owner's equity |
In May a garden designer received $6300$ dollars. That includes a deposit of $240$ for a job starting in June and $440$ paid late on an April invoice. She also sent $370$ of invoices for May's work that are still unpaid. What was her revenue for May, counted in the month the work was done?
Answer:
A landscaper's money in less money out for the year comes to $23800$ dollars. At the year end, clients owe $1300$ for work already done; a nursery's December bill of $490$ for plants already planted is unpaid; $220$ of the insurance paid this year covers next year; and $900$ of deposits received are for next year's jobs. Fill in the walk from the cash figure to the year's profit, in dollars.
| Amount | |
|---|---|
| After unpaid invoices | |
| After the unpaid bill | |
| After next year's insurance | |
| Profit for the year |
Lesson test: one question per skill, one attempt each, no hints. Your answers are checked when you submit.
A salon paid $1080$ dollars on the first day of its financial year for twelve months of insurance. How much of that is still prepaid after $10$ months, in dollars?
Answer:
You can build a month's profit from money that moved in other months, and show why owns always equals owes plus equity. Tell someone why a deposit is not revenue. Next: equipment whose cost is spread over the years it is used.
16. Your turn: rent of 1800 paid on the 1st of April for April, May and June, step 3
$1800 - 3 \times 600 = 0$
All used.