How to adjust accrued and prepaid expenses

Adjustments at the Balance Date and Preparation of Sole Proprietorship Financial Statements

What you need

• A trial balance before adjustments showing the expense balances already recorded (e.g. Rent Expense RM11,000).
• Extra information on expense rates and periods (e.g. monthly rent of RM1,000; the date and coverage of the insurance).
• A clear accounting period end date (e.g. 31 December 2023).
• An understanding of the matching principle and the accounting period concept.

Step by step

1. 1

   Identify the type of adjustment

   Read the additional notes below the trial balance. An accrued expense has been used up in the current period but not yet paid; a prepaid expense has been paid but partly relates to a future period. For Perniagaan Setia (year ended 31 December 2023): rent is RM1,000 per month but only RM11,000 was paid (accrued expense), and insurance of RM3,600 was paid on 1 October 2023 for a 12-month period (prepaid expense).

2. 2

   Calculate the accrued expense

   Rent should be RM1,000 x 12 = RM12,000 for the year, but only RM11,000 appears in the trial balance. So the accrued rent = RM12,000 - RM11,000 = RM1,000, which is the one month of rent still owing at 31 December 2023.

3. 3

   Record the accrued expense adjusting entry

   Record: Debit Rent Expense RM1,000; Credit Accrued Rent RM1,000. This increases the current period's rent expense and creates a liability, because an accrued expense is a current liability (an amount still owed to the landlord).

4. 4

   Calculate the prepaid expense

   The RM3,600 insurance covers 12 months starting 1 October 2023. For 2023, only 3 months (October-December) have been used = RM3,600 / 12 x 3 = RM900. The remaining 9 months (January-September 2024) = RM3,600 - RM900 = RM2,700 is the prepaid insurance.

5. 5

   Record the prepaid expense adjusting entry

   Record: Debit Prepaid Insurance RM2,700; Credit Insurance Expense RM2,700. This reduces the current period's insurance expense to only RM900 and creates an asset, because a prepaid expense is a current asset (a benefit not yet consumed).

6. 6

   Adjust the figures in the Income Statement

   In the expenses section of the Income Statement, show Rent Expense RM12,000 (RM11,000 + RM1,000 accrued) and Insurance Expense RM900 (RM3,600 - RM2,700 prepaid). These corrected expense figures are deducted from gross profit to arrive at the correct net profit.

7. 7

   Adjust the figures in the Statement of Financial Position

   Under Current Liabilities, show Accrued Rent RM1,000. Under Current Assets, show Prepaid Insurance RM2,700. Each adjustment appears once in the Income Statement and once again in the Statement of Financial Position, in line with double entry.

8. 8

   Check the balance and close the accounts

   Confirm each adjustment is recorded twice (one effect on the expense, one effect on a liability or asset). Re-check that total Assets = Liabilities + Owner's Equity still balances after all adjustments are entered, before finalising the statements.

Second example

Consider Kedai Harmoni, which closes its accounts on 31 December 2023. Staff wages are RM2,000 a month, but December's wages are still unpaid at the closing date. This is an accrued wages expense: record Debit Wages Expense RM2,000; Credit Accrued Wages RM2,000. In the Income Statement, Wages Expense is increased by RM2,000, while Accrued Wages RM2,000 is shown as a current liability in the Statement of Financial Position.

At the same time, Kedai Harmoni paid RM1,200 for advertising covering 6 months from 1 November 2023. By 31 December 2023, only 2 months (November-December) have been used = RM1,200 / 6 x 2 = RM400, so the remaining 4 months (RM800) is a prepaid expense. Record Debit Prepaid Advertising RM800; Credit Advertising Expense RM800. Advertising Expense in the Income Statement becomes only RM400, and Prepaid Advertising RM800 is shown as a current asset. Notice the same pattern: an accrual increases the expense and creates a liability, while a prepayment reduces the expense and creates an asset.

Common mistakes

Related chapter: Adjustments at the Balance Date and Preparation of Sole Proprietorship Financial Statements →

All procedures →