Balance day adjustments for prepaid expenses, accrued expenses, prepaid revenue and accrued revenue, and their effect on the calculation of net profit and the reporting of assets and liabilities

What this dot point is asking

VCAA wants you to explain why balance day adjustments are made and to record the four types: prepaid expenses, accrued expenses, prepaid revenue and accrued revenue. You must show the effect of each on net profit and on the assets and liabilities reported in the Balance Sheet.

Why adjust at balance day

The period assumption states that the life of the business is divided into equal periods so that reports can be prepared and performance compared. Balance day adjustments ensure each report only contains the revenue earned and the expenses incurred in that specific period, not amounts that belong to a different period.

The four adjustments

Prepaid expenses

A prepaid expense is an expense paid in cash before it is incurred, such as insurance paid 12 months in advance. At the time of payment it is recorded as an asset (a future economic benefit). At balance day, the portion that has now been consumed is transferred to expense:

• Debit the Expense account
• Credit Prepaid Expense (asset)

Net profit falls by the consumed portion. The remaining prepaid amount stays as a current asset.

Accrued expenses

An accrued expense is an expense incurred but not yet paid, such as wages owing at balance day. The benefit has been consumed, so it must be recognised:

• Debit the Expense account
• Credit Accrued Expense (liability)

Net profit falls and a current liability is created.

Prepaid revenue

Prepaid (unearned) revenue is cash received before the revenue is earned, such as a customer paying in advance. When received it is a liability because the business owes a service or goods. At balance day, the earned portion is recognised:

• Debit Prepaid Revenue (liability)
• Credit the Revenue account

Net profit rises by the earned portion and the liability falls.

Accrued revenue

Accrued revenue is revenue earned but not yet received, such as interest earned but not yet banked. It is recognised because it has been earned:

• Debit Accrued Revenue (asset)
• Credit the Revenue account

Net profit rises and a current asset is created.

Effect on the reports

Each adjustment changes both reports at once, which is why the system stays balanced. An expense adjustment lowers net profit in the Income Statement and either lowers an asset or raises a liability in the Balance Sheet. A revenue adjustment raises net profit and either raises an asset or lowers a liability. Without these adjustments, profit would be measured on a cash basis and would not faithfully represent performance for the period.