Accrual Accounting and Balance Day Adjustments - TCE Accounting (Tasmania)
“Explain accrual accounting and process balance day adjustments for accrued and prepaid items.”
Accrual accounting recognises revenue when earned and expenses when incurred, not when cash moves. Balance day adjustments correct the accounts at period end for timing differences: accrued (owing but unpaid) and prepaid (paid in advance) expenses, plus accrued and unearned revenue.
What this dot point is asking
Unit 3 prepares reports using accrual accounting, which means profit must measure what was earned and used up in the period, regardless of cash timing. Because cash and the underlying event rarely line up exactly, the ledger needs balance day adjustments before the statements are prepared.
The matching principle
Profit is revenue earned in the period less the expenses incurred to earn it. If an expense relates to this period but has not been paid, it must still be counted. If cash has been paid for something belonging to next period, it must be removed from this period. The four classic adjustments handle these timing gaps.
An entry made at the end of the reporting period to bring revenue and expense accounts into line with the accrual basis, so the income statement and balance sheet reflect what was earned and incurred rather than what was paid.
The four adjustments
- Accrued expense: an expense incurred but not yet paid (for example, wages owing). Debit the expense, credit a liability (accrued expense).
- Prepaid expense: cash paid for a future benefit (for example, insurance in advance). The unused portion is an asset. Debit Prepaid (asset), credit the expense.
- Accrued revenue: revenue earned but not yet received (for example, interest due). Debit an asset (accrued revenue), credit the revenue.
- Unearned revenue: cash received before the service is provided. The unearned part is a liability. Debit the revenue, credit Unearned revenue (liability).
Every balance day adjustment changes a revenue or expense (income statement) and creates or changes an asset or liability (balance sheet). If your adjustment touches only one statement, something is wrong.
Worked example
Accrued wages
Wages of for the last three days of June are unpaid at balance day.
- Debit Wages expense (raises this year's expense)
- Credit Accrued wages (a current liability)
Effect: net profit falls by ; current liabilities rise by .
Prepaid insurance
On 1 April the business paid for twelve months of insurance, all recorded as expense.
At 30 June, nine months () are still unused and belong to next year.
- Debit Prepaid insurance (a current asset)
- Credit Insurance expense (reduces this year's expense)
Effect: net profit rises by compared with leaving it unadjusted; current assets rise by .
Time-apportionment
Many adjustments require splitting an amount across periods. The technique is to work out the fraction of the period the amount relates to. If insurance was paid on 1 April for the year ahead and the year ends 30 June, then three months () have been used and nine months () are prepaid. Multiply the total by the relevant fraction. The same logic applies to accrued interest on a loan, prepaid rent, and unearned revenue spread over future months. Reading the dates carefully and stating the fraction is where most marks are earned or lost on these questions.
For any prepaid or accrued item, first decide how much benefit has been used up or earned in this period and how much belongs to another period. Then choose the entry. The portion that belongs to this period stays as an expense or revenue; the portion that belongs to another period becomes an asset (prepaid, accrued revenue) or a liability (accrued expense, unearned revenue).
Reversing entries (awareness)
Some accruals are reversed at the start of the next period so the eventual cash payment can be recorded normally without double counting. For example, after accruing wages at 30 June, the accrual may be reversed on 1 July so that when the wages are actually paid the full payment can simply be debited to Wages expense. At TASC level the focus is on getting the balance day adjustment itself correct; reversing entries are useful background for understanding why the accrued liability does not linger.
How adjustments flow into the reports
Every balance day adjustment changes one income statement account (a revenue or expense) and one balance sheet account (an asset or liability). After the adjustments are posted, the adjusted trial balance feeds the income statement and balance sheet. Because the effects are paired, a single wrong adjustment moves both profit and the balance sheet, which is why the balance sheet failing to balance often points back to an adjustment error. This is the link between this topic and preparing the financial statements.
Why this matters
Without these adjustments the income statement would report cash flows rather than performance, and the balance sheet would omit real assets and liabilities. Exam questions almost always include several balance day adjustments before asking for the statements, so a wrong adjustment cascades into a wrong profit and a balance sheet that will not balance.
A prepaid expense removes cost from this period (it is an asset for next period), while an accrued expense adds cost to this period (it is a liability now). Reversing them moves profit the wrong way. Decide first whether the benefit has been used up or paid in advance, then choose the entry.
Exam-style questions
Questions in the style of TASC 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 marksProcess the following balance day adjustments at 30 June and state the effect of each on net profit and on the balance sheet. (1) Wages of 3\,600 was paid on 1 April for the year ahead and recorded entirely as expense. (3) Commission revenue of $900 has been earned but not yet received. (4) $1\,200 was received in advance for services to be provided next year and recorded as revenue.Show worked answer →
Give the entry and the dual effect for each adjustment.
(1) Accrued wages: Debit Wages expense ; Credit Accrued wages . Net profit down ; current liabilities up .
(2) Prepaid insurance: 9 of 12 months remain, . Debit Prepaid insurance ; Credit Insurance expense . Net profit up (expense reduced); current assets up .
(3) Accrued revenue: Debit Accrued commission ; Credit Commission revenue . Net profit up ; current assets up .
(4) Unearned revenue: Debit Service revenue ; Credit Unearned revenue . Net profit down ; current liabilities up .
Markers reward the correct entry and direction for each of the four adjustments, the time-apportionment of insurance (), and the dual effect on both profit and the balance sheet.
Practice4 marksExplain the difference between the cash basis and the accrual basis of accounting, and explain why the accrual basis gives a more accurate measure of profit for a period.Show worked answer →
A full 4 mark answer contrasts the two bases and justifies accrual.
Under the cash basis, revenue and expenses are recorded only when cash is received or paid. Under the accrual basis, revenue is recognised when earned and expenses when incurred, regardless of when cash moves.
The accrual basis gives a more accurate measure of profit because it matches the revenue earned in a period against the expenses incurred to earn it, including amounts owing (accruals) and excluding amounts paid in advance (prepayments). The cash basis can distort profit, for example by ignoring wages owing at year end or counting a full year's insurance paid in advance as this year's expense. Balance day adjustments are what convert the records to the accrual basis. Markers reward the timing distinction and the matching argument that accrual reports performance rather than cash movement.