At the end of the accounting period, some income and expenses have not been recorded correctly against the period they belong to. Adjustments are made so that the financial statements show the accurate figures for that period.
Cash Basis and Accrual Basis
The cash basis records income when cash is received and expenses when cash is paid, regardless of when the transaction actually occurred. The accrual basis records income when it is earned and expenses when they are incurred, even if the cash has not yet been received or paid.
Financial statements that comply with MFRS standards are prepared on the accrual basis, because it follows the matching concept — expenses are matched against the income of the same period.
Key idea
Accrual basis: income and expenses are recognised in the period they are earned or incurred, not by the flow of cash.
The Four Types of Adjustment
- Prepaid expense — an expense already paid but relating to a future period.
- Accrued expense — an expense already incurred but not yet paid.
- Accrued income — income already earned but not yet received.
- Prepaid income (income received in advance) — income already received but relating to a future period.
Example
A business pays rent of RM12,000 for 12 months on 1 October. By 31 December (year end), only 3 months (RM3,000) relate to the current year. The remaining RM9,000 is a prepaid expense for next year. The rent expense charged to the profit and loss account is only RM3,000.
Why Adjustments Matter
Without adjustments, net profit and the financial position would be misstated. For example, if an accrued expense is ignored, expenses are understated and net profit is overstated. Besides the four income-and-expense adjustments, other adjustments include depreciation of non-current assets and provision for doubtful debts. All these adjustments are carried out before the final financial statements are prepared.
Common Mistakes
Many students confuse the date the cash moves with the period it relates to. Under the accrual basis, what matters is when the benefit is used or the service is given. For example, December salaries paid in January are still an expense of the current year because the staff worked during that period. Small businesses sometimes use the cash basis because it is simple, but it does not follow the matching concept and is not allowed for formal reporting under MFRS.
Remember
Prepayments and accruals arise because the timing of cash differs from the accounting period. The accrual basis matches figures to the correct period.