Balance day adjustments in QCE Accounting Unit 3
“Apply the accrual basis to record balance day adjustments for prepaid and accrued expenses, accrued and unearned revenue, and depreciation, so that the income statement and balance sheet are accurate”
Balance day adjustments make the accrual basis work. A prepaid expense is an expense paid in advance: the unused part is a current asset, so you remove it from the expense. An accrued expense is incurred but unpaid: you add it to the expense and create a current liability. Accrued revenue is earned but not yet received: you add it to revenue and create a current asset. Unearned revenue is received in advance: the unearned part is a current liability, so you remove it from revenue. Each adjustment shifts an amount between an income statement account and a balance sheet account so the period reports only what it earned and incurred.
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What this dot point is asking
QCAA wants you to apply the accrual basis at balance day, the last day of the reporting period. Under accrual accounting, revenue is recognised when earned and expenses when incurred, regardless of when cash moves. Because cash and the actual earning or incurring rarely line up exactly, the records need adjusting before the financial statements are drawn up. You must record prepaid expenses, accrued expenses, accrued revenue and unearned revenue, each of which creates or changes a current asset or current liability and corrects the profit figure.
The accrual basis and why adjustments exist
The accrual basis recognises revenue when it is earned and expenses when they are incurred, matching them to the period they belong to rather than to the period cash changes hands. During the year transactions are often recorded on a cash basis for convenience, so at balance day the records contain amounts that relate to other periods. Balance day adjustments correct this, applying the matching concept (expenses matched to the revenue and the period they help generate) and ensuring the income statement shows true profit and the balance sheet shows true assets and liabilities.
The four adjustment types
- Prepaid expense (asset)
- The business has paid for something it has not yet fully used, such as insurance paid 12 months in advance. The unused portion is an asset. Adjustment: debit Prepaid Expense (current asset), credit the expense. This reduces the expense to only the amount used in the period.
- Accrued expense (liability)
- The business has used something it has not yet paid for, such as wages owing at year end. Adjustment: debit the expense, credit Accrued Expense (current liability). This increases the expense to include what was incurred but unpaid.
- Accrued revenue (asset)
- The business has earned revenue it has not yet received, such as interest earned but not yet credited. Adjustment: debit Accrued Revenue (current asset), credit the revenue. This increases revenue to include what was earned but uncollected.
- Unearned revenue (liability)
- The business has received cash for something it has not yet delivered, such as a deposit for goods to be supplied next period. The unearned portion is a liability. Adjustment: debit the revenue, credit Unearned Revenue (current liability). This reduces revenue to only the amount earned.
Depreciation is also a balance day adjustment: it allocates part of a non-current asset's cost to the period as an expense and accumulates against the asset. It is treated in full on the non-current assets page; the key point here is that it is recorded at balance day along with the other adjustments.
The effect on the statements
Every adjustment touches one income statement account and one balance sheet account. Expense adjustments change profit and create an asset (prepaid) or liability (accrued). Revenue adjustments change profit and create an asset (accrued) or liability (unearned). Because they alter profit, getting them wrong misstates both the income statement and the balance sheet, which is why they are made before the statements are prepared and why the closing capital figure depends on them.
The data
At 30 June, Marlin Trading must adjust:
- Insurance of $2,400 was paid on 1 April for 12 months. At 30 June only 3 months ($600) has been used.
- Wages of $900 are owing for the last week of June, unpaid.
- Interest of $150 has been earned on a term deposit but not yet received.
- A customer paid $1,200 on 25 June for goods to be delivered in July.
The adjusting entries
| Adjustment | Debit | Credit |
|---|---|---|
| 1 Prepaid insurance ($2,400 - $600 used) | Prepaid Insurance 1,800 | Insurance 1,800 |
| 2 Accrued wages | Wages 900 | Accrued Wages 900 |
| 3 Accrued interest | Accrued Interest 150 | Interest Revenue 150 |
| 4 Unearned revenue | Sales 1,200 | Unearned Revenue 1,200 |
Reading the result
Adjustment 1 cuts insurance expense to the $600 actually used and reports $1,800 as a current asset. Adjustment 2 raises wages expense by $900 and creates a $900 current liability. Adjustment 3 adds $150 to revenue and creates a $150 current asset. Adjustment 4 removes $1,200 from sales (it is not yet earned) and creates a $1,200 current liability. The net effect on profit is - 1,800 expense + 900 expense + 150 revenue - 1,200 revenue, which lifts profit by $750 overall while correctly stating four balance sheet items.
- Mixing up which adjustments are assets and which are liabilities
- Prepaid expense and accrued revenue are assets; accrued expense and unearned revenue are liabilities.
- Adjusting for the wrong portion
- A prepaid expense adjustment uses the unused part, not the total paid; an unearned revenue adjustment uses the unearned part, not the total received.
- Leaving adjustments until after the statements
- Adjustments must be recorded first, because they change the profit and the balance sheet figures the statements report.
- Forgetting that adjustments have no cash effect
- They reclassify amounts between periods; no cash moves, so they never appear in a cash budget.
Exam-style questions
Questions in the style of QCAA exam questions on this dot point, each with a worked answer. They are written by ExamExplained unless tagged "Past paper"; the year shows the paper a question is modelled on.
Practice8 marksRead Case study 1 (Stimulus 1) in the stimulus book. Record the balance day adjustments in the worksheet for the two issues identified. Add the further accounts required and complete the Adjusted Balance column for the affected accounts. [Issue 1: two remaining freezers are to be recorded at net realisable value - current selling price $975 each, original cost $1 399.50 each, marketing costs $145 for the two. Issue 2: on 20 June 2023 the business received 40 cents in the dollar from a customer whose $8 790 account had been written off as a bad debt; GST was applicable on the initial sale. Round to the nearest dollar.]Show worked answer →
Two balance day adjustments are needed. Work each from the stimulus figures.
Issue 1, write inventories down to net realisable value (NRV). NRV is selling price less costs to sell: (975 x 2) - 145 = 1 950 - 145 = 2 799. Because NRV ($1 805) is below cost ($2 799), inventory must be written down by 2 799 - 1 805 = $994.
- DR Inventory write-down (expense) 994, CR Inventories 994. Inventories Adjusted Balance = 4 590 - 994 = $3 596.
Issue 2, recovery of a debt previously written off. The amount received is 40% of 3 516 including GST. Split out GST: 3 516 / 11 = 3 196.
- DR Cash at Bank 3 516, CR Bad debts recovered 3 196, CR GST Clearing 320.
Markers reward the NRV calculation, the resulting adjusted Inventories figure, and correctly splitting the recovery into the GST and revenue components.
Practice1 markReversing entries are performed to (A) close revenue and expense accounts. (B) create temporary asset and liability accounts. (C) cancel relevant balance day adjustment entries. (D) match revenues and expenses to the correct period.Show worked answer →
The correct answer is (C) cancel relevant balance day adjustment entries.
A reversing entry is made on the first day of the new period and is the exact opposite of an accrual balance day adjustment made on the last day of the previous period (for example an accrued expense or accrued revenue). Reversing the accrual means that when the actual cash payment or receipt is later recorded in the new period, it can be entered in the normal way without double counting the amount already recognised at balance day.
(A) describes closing entries, not reversing entries. (D) describes the purpose of the original balance day adjustment under the accrual basis, not the reversal. (B) is incorrect because reversing entries remove, rather than create, the temporary accrual accounts.