Balance day adjustments under accrual accounting (VCE Accounting Unit 3)
“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”
Balance day adjustments allocate revenues and expenses to the period they actually relate to, applying the accrual and period assumptions. Prepaid and accrued items shift amounts between the Income Statement and Balance Sheet so net profit and financial position are both faithfully represented at balance day.
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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
Accrual accounting recognises revenue when it is earned and expenses when they are incurred, regardless of when cash is received or paid. This is required so the Income Statement matches revenues against the expenses incurred to earn them.
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.
Prepaid expense and prepaid revenue both start on the Balance Sheet and move partly to the Income Statement. Accrued expense and accrued revenue both start as an earned or incurred amount and create a new Balance Sheet item. Two adjustments lower profit (expenses) and two raise it (revenues).
Scenario
On 1 October the business paid 2,400 dollars for 12 months of insurance and recorded it as Prepaid Insurance. The reporting period ends on 31 December. At 31 December, wages of 600 dollars have been incurred but will not be paid until January.
Prepaid insurance adjustment
Months consumed from 1 October to 31 December = 3 months. Monthly cost = 2,400 divided by 12 = 200 dollars. Insurance expense for the period = 200 times 3 = 600 dollars.
- Debit Insurance Expense 600
- Credit Prepaid Insurance 600
Prepaid Insurance remaining = 2,400 minus 600 = 1,800 dollars, reported as a current asset.
Accrued wages adjustment
- Debit Wages Expense 600
- Credit Accrued Wages 600
Accrued Wages of 600 dollars is reported as a current liability.
Effect on net profit
Total extra expense recognised = 600 (insurance) plus 600 (wages) = 1,200 dollars. Net profit is therefore 1,200 dollars lower than it would have been with no adjustments, and this matches the benefits actually consumed in the period.
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.
Prepaid revenue is cash received in advance, so it is a liability (you owe the customer). Accrued revenue is earned but not yet received, so it is an asset (the customer owes you). Students often reverse these. Ask whether the cash has already been received: if yes and the work is not done, it is prepaid revenue; if no and the work is done, it is accrued revenue.
Exam-style questions
Questions in the style of VCAA 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.
2020 VCAA-style3 marksOn Tuesday 30 June 2020, wages owing to employees totalled $1 200. With reference to one accounting assumption, explain why this balance day adjustment is necessary.Show worked answer →
Name the assumption, then justify the accrued expense for 3 marks.
The relevant assumption is the accrual basis: revenues are recognised when earned and expenses when incurred, regardless of when cash is paid.
The employees have already provided their labour up to 30 June, so the $1 200 is an expense incurred in this period even though it has not yet been paid.
The adjustment (debit Wages, credit Accrued Wages) ensures the full wages expense is matched against the revenue of the current period, so net profit is not overstated, and it records a present obligation as a current liability so the Balance Sheet faithfully represents what is owed.
2025 VCAA-style4 marksA three-month advertising contract for $16 500 (including GST) was paid on 10 February 2025 and an adjusting entry was made on 31 March, at the end of the first quarter. Show how the following two accounts would appear in the General Ledger at 31 March 2025: Prepaid Advertising; Advertising.Show worked answer →
The GST-exclusive amount is 16 500 / 11 = $15 000 for three months, so $5 000 per month. From 1 March to 31 March, one month (March) has been consumed.
Prepaid Advertising (asset): debit side 10 Feb Bank/GST Clearing $15 000; credit side 31 Mar Advertising $5 000 and 31 Mar Balance c/d $10 000. The closing balance of $10 000 carries the two remaining months (April, May) as a current asset.
Advertising (expense): debit side 31 Mar Prepaid Advertising $5 000. This $5 000 is the portion incurred in the quarter and is transferred to the Income Statement.
One mark each for the prepayment entry, the $5 000 transfer, the $10 000 closing asset balance, and correct cross-references and dates.