Timing and the accrual basis: why accounts are adjusted
Under the accrual basis, income is recorded when earned and expenses when incurred. Adjusting entries at the period end put each item in the right period.
Why timing matters
A business lives for many years, but owners, lenders and the tax authority need results for each period (the time period concept). Cash often moves in a different period from the work done. Under the cash basis, income and expenses are recorded only when cash is received or paid. Under the accrual basis, which the Sri Lanka Accounting Standards require for financial statements (except cash flow information), income is recorded when earned and expenses when incurred. At the end of each period, adjusting entries move amounts into the right period.
Worked example: cash basis vs accrual basis profit
In March 2026 a Colombo IT firm (a) finished a job worth Rs. 300,000, to be paid in April; (b) received Rs. 60,000 in advance for work to be done in April; (c) paid March salaries of Rs. 120,000 in March; (d) will pay the March rent of Rs. 40,000 in April. Find the March profit on each basis.
- Cash basis receipts in March: only the advance, 60,000.
- Cash basis payments in March: salaries, 120,000.
- Cash basis result: 60,000 − 120,000 = −60,000, a loss of 60,000.
- Accrual basis income earned in March: the finished job, 300,000. The advance is not earned until April.
- Accrual basis expenses incurred in March: salaries 120,000 + rent 40,000 = 160,000.
- Accrual basis profit: 300,000 − 160,000 = 140,000.
Cash basis: a loss of Rs. 60,000. Accrual basis: a profit of Rs. 140,000. The accrual figure shows what March really earned.
The main types of adjusting entries
| Type | Situation | Adjusting entry |
|---|---|---|
| Prepaid expense (deferral) | Cash paid before the expense is used | Dr Expense, Cr Prepaid asset (for the part used up) |
| Unearned revenue (deferral) | Cash received before the work is done | Dr Unearned revenue, Cr Revenue (for the part earned) |
| Accrued revenue (accrual) | Work done, not yet billed or received | Dr Receivable, Cr Revenue |
| Accrued expense (accrual) | Expense incurred, not yet paid | Dr Expense, Cr Accrued expense (liability) |
| Estimates | Depreciation, doubtful debts | Dr Expense, Cr Accumulated depreciation or Allowance |
Deferrals and accruals
Rules for every adjusting entry
- It is made at the end of the period, through the general journal.
- It always involves one income statement account and one statement of financial position account.
- It never involves cash or bank.
- It applies the accrual and matching concepts.
A Sri Lankan insurer collects annual premiums in advance, and a private school collects term fees before teaching. At the year end both must show the unearned part as a liability (unearned revenue), not as this year's income.
Short answer: “Distinguish the cash basis from the accrual basis.” The cash basis records income and expenses when cash moves; the accrual basis records them when earned or incurred, whatever the timing of cash.
Structured question: “Show the profit for a month under the cash basis and the accrual basis from the given data.” List receipts and payments for the cash basis, then income earned and expenses incurred for the accrual basis, and explain the difference.
Essay: “Why are adjusting entries needed? Explain the types of adjusting entries with examples.” Explain the time period and accrual concepts, then prepaid expenses, unearned revenue, accrued revenue, accrued expenses and estimates, each with a rupee example and entry.
Every adjusting entry = one income statement account + one SFP account, and never cash. Deferral: cash first. Accrual: cash later.