Explain accrual accounting and process balance day adjustments for accrued and prepaid items.

Why accrual accounting requires balance day adjustments, and how to record accrued expenses, prepaid expenses, accrued revenue and unearned revenue.

Generated by Claude Opus 4.77 min answerUpdated 2026-05-30

Reviewed by: AI editorial process; not yet individually human-reviewed

Have a quick question? Jump to the Q&A page

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.

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).

Worked example

Two adjustments at 30 June

Accrued wages

Wages of $1\,800$ for the last three days of June are unpaid at balance day.

Debit Wages expense $1\,800$ (raises this year's expense)
Credit Accrued wages $1\,800$ (a current liability)

Effect: net profit falls by $1\,800$ ; current liabilities rise by $1\,800$ .

Prepaid insurance

On 1 April the business paid $2\,400$ for twelve months of insurance, all recorded as expense.
At 30 June, nine months ( $2\,400 \times \frac{9}{12} = 1\,800$ ) are still unused and belong to next year.

Debit Prepaid insurance $1\,800$ (a current asset)
Credit Insurance expense $1\,800$ (reduces this year's expense)

Effect: net profit rises by $1\,800$ compared with leaving it unadjusted; current assets rise by $1\,800$ .

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.