Content Standard 8.1

Cash Basis and Accrual Basis Accounting and Types of Adjustments

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Explanation

There are two bases of accounting that can be used to record a business's transactions: the cash basis and the accrual basis. Under the cash basis, revenue is recognised only when cash is received and expenses only when cash is paid, regardless of the period in which the transaction took place. The cash basis is simple and is often used by very small businesses, but it does not show the true performance of a business because revenue and expenses are not matched to the correct period.

Under the accrual basis, revenue is recognised when it is earned and expenses are recognised when they are incurred during an accounting period, whether or not the cash has yet been received or paid. A sole proprietorship must prepare its financial statements on the accrual basis so that the profit or loss reported reflects the true performance for that period. The accrual basis follows the matching concept, meaning the expenses of a period must be matched against the revenue earned in the same period.

An adjustment is a correction made to the accounting records on the balance date (the last day of the accounting period) so that the revenue and expense figures reported belong to that period only. During the year, some expenses and revenue are recorded at the amounts paid or received in cash. At the year end, these amounts may be more or less than the amounts that should be charged to that period, so adjustments are needed to correct them before the financial statements are prepared.

The types of adjustments on the balance date include accrued expenses (expenses incurred but not yet paid), prepaid expenses (expenses paid for a future period), accrued income (income earned but not yet received), income received in advance (income received for a future period), depreciation of non-current assets, bad debts, bad debts recovered, provision for doubtful debts, and closing inventory. Each of these adjustments has its own double entry that adjusts the relevant accounts.

Adjustments are needed to comply with the accrual basis, the matching concept and the prudence concept, so that the financial statements give a true and fair view. Adjustments affect two statements: they change the expense and revenue figures in the Income Statement (thus changing net profit), and they create current assets (for example prepaid expenses, accrued income) or current liabilities (for example accrued expenses, income received in advance) in the Statement of Financial Position. Without adjustments, the reported net profit and financial position would be misstated.

Worked examples

Accrued expense: shop rent of Restoran Selera Kampung

Restoran Selera Kampung rents its premises at RM1,200 per month, so the rent expense for a year should be RM14,400. During the year ended 31 December 2024, the business only paid RM13,200 (11 months). The remaining one month of RM1,200 is still unpaid at the balance date.

Accrued expense adjustment: Debit Rent Expense RM1,200; Credit Accrued Rent RM1,200.

Effect: In the Income Statement, the rent expense charged is RM14,400 (RM13,200 + RM1,200), not RM13,200. In the Statement of Financial Position, Accrued Rent RM1,200 is shown as a current liability because it is an unpaid debt of the business.

Prepaid expense: insurance of Perniagaan Indah Enterprise

On 1 July 2024 Perniagaan Indah Enterprise paid an insurance premium of RM3,600 for one year (1 July 2024 to 30 June 2025). At the balance date of 31 December 2024, only 6 months (RM1,800) belong to the current period; the remaining 6 months (RM1,800) relate to next year.

Prepaid expense adjustment: Debit Prepaid Insurance RM1,800; Credit Insurance Expense RM1,800.

Effect: The insurance expense charged in the Income Statement is only RM1,800. Prepaid Insurance RM1,800 is shown as a current asset in the Statement of Financial Position because it is a benefit not yet used.

Income received in advance: rent received by Perniagaan Maju Jaya

Perniagaan Maju Jaya sublets part of its shop and received rent of RM6,000 during the year ended 31 December 2024. Of this amount, RM1,000 is rent for January 2025 paid early by the tenant.

Income received in advance adjustment: Debit Rent Revenue RM1,000; Credit Rent Received in Advance RM1,000.

Effect: The rent revenue recognised in the Income Statement falls to RM5,000. Rent Received in Advance RM1,000 is shown as a current liability because the business owes a service (rental space) for a future period.

Practice

Explain the difference between the cash basis and the accrual basis, and state which basis is used to prepare the financial statements of a sole proprietorship.

Answer: The cash basis recognises revenue only when cash is received and expenses only when cash is paid, regardless of when the transaction took place. The accrual basis recognises revenue when it is earned and expenses when they are incurred during the accounting period, whether or not the cash has been received or paid. The financial statements of a sole proprietorship are prepared using the accrual basis because it follows the matching concept and gives a true and fair view of the actual profit or loss and financial position of the business.

On 31 December 2024, salaries of RM2,000 owed to the employees of Perniagaan Ceria are still unpaid. State the type of adjustment, the double entry, and its effect on the financial statements.

Answer: Type of adjustment: accrued expense (accrued salaries). Double entry: Debit Salaries Expense RM2,000; Credit Accrued Salaries RM2,000. Effect: The salaries expense in the Income Statement increases by RM2,000, thereby reducing net profit. Accrued Salaries RM2,000 is shown as a current liability in the Statement of Financial Position because it is an amount still owing by the business at the balance date.

Perniagaan Setia paid rent of RM4,800 for the period 1 October 2024 to 30 September 2025. The financial year ends 31 December 2024. Calculate the rent expense for 2024 and make the necessary adjustment.

Answer: The period falling within 2024 is 3 months (October to December). Monthly rate = RM4,800 / 12 = RM400. Rent expense for 2024 = RM400 x 3 = RM1,200. The remaining 9 months (RM400 x 9 = RM3,600) are a prepaid expense for 2025. Adjustment: Debit Prepaid Rent RM3,600; Credit Rent Expense RM3,600. Rent expense in the Income Statement is RM1,200, while Prepaid Rent RM3,600 is shown as a current asset.

State three reasons why adjustments are needed on the balance date before the financial statements are prepared.

Answer: First, to comply with the accrual basis and the matching concept so that expenses are matched against the revenue of the same period. Second, to ensure that the net profit or net loss reported is accurate and not misstated. Third, to ensure that the assets, liabilities and equity in the Statement of Financial Position are stated at their correct values, for example by creating current assets such as prepaid expenses or current liabilities such as accrued expenses, so that the statements give a true and fair view.

Exam tips

Key terms

Accrual basis: An accounting basis that recognises revenue when earned and expenses when incurred, regardless of cash receipt or payment.
Adjustment: A correction made to the records on the balance date so that the revenue and expense figures are accurate for the period concerned.
Accrued expense: An expense incurred during the current period but not yet paid; recorded as a current liability.
Income received in advance: Income that has been received but belongs to a future period; recorded as a current liability.

Source: DSKP KSSM Prinsip Perakaunan Tingkatan 4

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