Marisol Ferrer owns a corner shop in Valencia and her financial year ends on 31 December. Her shop insurance account held the entries below, and $410 of the...

(a) Insurance account for the year ended 31 December [8]

An expense account collects what has been paid on the debit side, and at the year end the amount actually used up in the period is transferred to the income statement. Anything paid in advance is not an expense of this year, so it is carried down as a debit balance representing an asset.

Working: the debit side totals $360 plus $1,080 plus $1,140 plus $1,200, which is $3,780. Of that, $410 relates to cover for the year ahead, so the charge to the income statement is $3,780 less $410, that is $3,370. The balance of $410 is brought down on the debit side on 1 January.

(b) Where the closing balance appears [3]

The $410 is a prepayment, shown as a current asset in the statement of financial position, normally grouped with other receivables. It is an asset because Marisol has already paid for insurance cover that the shop has yet to receive, so the insurer owes her a service rather than money.

(c) How the accruals concept settles the charge [4]

The accruals concept requires expenses to be matched to the period whose revenue they help to earn, not to the period in which the money happened to leave the bank. Cash paid during the year came to $1,080 plus $1,140 plus $1,200, which is $3,420, but that is not the charge.

1. The $360 brought down was paid in the previous year yet covers part of this year, so it is added into this year's cost.
2. The $410 was paid this year but covers next year, so it is taken out and carried forward as a prepayment.
3. The charge is therefore $3,420 plus $360 less $410, that is $3,370, which is the cover actually consumed in the year.

Without this adjustment the profit for the year would be understated by $50, the net effect of the two prepayments, and the shop would appear to hold no asset for the cover it has already bought.