Q.You are given the following information :
Profit before adjustments : ₹ 40,000
Adjustments required :
Outstanding wages : ₹ 5,000
Prepaid insurance : ₹ 1,500
Accrued income : ₹ 2,000
Depreciation on machinery : ₹ 3,000
Show how the above adjustments affect the profit and calculate the net profit.
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🔒 Start your 14-day free trial to unlock the full solution →Concept understanding — Accrual Basis Accounting
Accrual Basis Accounting – A First Look
Think about a newspaper delivery. You pay for a month's subscription at the start. The newspaper company gets your money on 1st April, but it hasn't earned that money yet — it still has to deliver papers for the next 30 days. The company's profit for April isn't the cash it collected; it's the revenue from the papers actually delivered in April.
That's the core intuition behind accrual accounting: record income when it is earned, not when cash is received; record expenses when they are incurred, not when cash is paid.
The Precise Meaning
Under the accrual basis, transactions are recorded in the books of account at the time they occur, regardless of when the actual cash changes hands.
- Revenue is recognised when the goods are sold or services are rendered — even if the customer will pay later.
- Expenses are recognised when the benefit is consumed or the liability arises — even if the payment will be made later.
This is the opposite of cash basis accounting, where you record only when cash is received or paid.
The accrual basis is mandatory under the Companies Act, 2013 for all companies, and it is the foundation of the Generally Accepted Accounting Principles (GAAP) followed in India.
Why It Matters
Accrual accounting gives a true and fair view of the business's financial performance and position.
- Matching Principle: Expenses are matched with the revenues they help generate in the same period. If you sell goods in March but receive payment in April, the sale belongs to March's profit calculation, not April's.
- Realistic Profit: Profit under accrual basis reflects the actual economic activity of the period, not just the timing of cash flows.
- Better Decision-Making: Owners, investors, and creditors see what the business has earned and owes, not just what it has in the bank.
A common mistake: thinking profit equals cash in hand. Under accrual accounting, a business can show a healthy profit but have very little cash (if most sales are on credit), or show a loss but have plenty of cash (if it collected old debts while making few new sales).
Accounting Treatment – The Journal Entries
Accrual accounting gives rise to two special types of accounts: Outstanding Expenses and Accrued Incomes (also called Prepaid Expenses and Unearned Incomes on the other side).
1. Outstanding Expenses (Expense incurred but not yet paid)
Example: Salary for March is ₹50,000, but it will be paid in April.
Journal Entry (at the end of March):
| Date | Particulars | L.F. | Debit (₹) | Credit (₹) |
|---|---|---|---|---|
| March 31 | Salary A/c Dr. | 50,000 | ||
| To Outstanding Salary A/c | 50,000 | |||
| (Being salary for March due but not paid) |
- Debit: Salary A/c (expense is recorded in the period it belongs to)
- Credit: Outstanding Salary A/c (a liability — the business owes this money)
When paid in April:
| Date | Particulars | L.F. | Debit (₹) | Credit (₹) |
|---|---|---|---|---|
| April 10 | Outstanding Salary A/c Dr. | 50,000 | ||
| To Cash/Bank A/c | 50,000 | |||
| (Being outstanding salary paid) |
2. Accrued Income (Income earned but not yet received)
Example: Commission earned ₹20,000 in March, but will be received in April.
Journal Entry (at the end of March):
| Date | Particulars | L.F. | Debit (₹) | Credit (₹) |
|---|---|---|---|---|
| March 31 | Accrued Commission A/c Dr. | 20,000 | ||
| To Commission Income A/c | 20,000 | |||
| (Being commission earned but not received) |
- Debit: Accrued Commission A/c (an asset — the business is owed this money)
- Credit: Commission Income A/c (revenue is recorded in the period it was earned)
When received in April:
| Date | Particulars | L.F. | Debit (₹) | Credit (₹) |
|---|---|---|---|---|
| April 15 | Cash/Bank A/c Dr. | 20,000 | ||
| To Accrued Commission A/c | 20,000 | |||
| (Being accrued commission received) |
3. Prepaid Expenses (Expense paid in advance)
Example: Insurance premium of ₹12,000 paid on 1st January for the full year.
Journal Entry (at the end of the accounting year, say 31st March):
Only 3 months' insurance (Jan–Mar) has been used. The remaining 9 months' worth (₹9,000) is still an asset.
| Date | Particulars | L.F. | Debit (₹) | Credit (₹) |
|---|---|---|---|---|
| March 31 | Prepaid Insurance A/c Dr. | 9,000 | ||
| To Insurance A/c | 9,000 | |||
| (Being insurance prepaid for the remaining period) |
- Debit: Prepaid Insurance A/c (asset)
- Credit: Insurance A/c (reduces the expense to only the consumed portion)
4. Unearned Income (Income received in advance)
Example: Rent received ₹30,000 on 1st March for three months (March, April, May).
Journal Entry (at the end of March):
Only one month's rent (₹10,000) has been earned. The remaining ₹20,000 is a liability. …
On the accrual basis, outstanding expenses and depreciation reduce profit, while prepaid expenses and accrued income increase it. Applying these four adjustments to the ₹40,000 profit gives the net profit. …
Outstanding wages (−5,000) and depreciation (−3,000) reduce profit; prepaid insurance (+1,500) and accrued income (+2,000) increase it. Net profit = 40,000 − 5,000 + 1,500 + 2,000 − 3,000 = ₹35,500.
Effect of each adjustment
| Adjustment | Nature | Effect on profit | ₹ |
|---|---|---|---|
| Outstanding wages | Expense of this year not yet paid — added to expenses | Decrease | (5,000) |
| Prepaid insurance | Expense paid in advance — removed from this year's expenses | Increase | +1,500 |
| Accrued income | Income earned but not yet received — added to income | Increase | +2,000 |
| Depreciation on machinery | Non-cash expense charged against profit | Decrease | (3,000) |
Calculation of Net Profit
| Particulars | ₹ |
|---|---|
| Profit before adjustments | 40,000 |
| Less: Outstanding wages | (5,000) |
| Add: Prepaid insurance | 1,500 |
| Add: Accrued income | 2,000 |
Showing the 12 most recent of 22 on this concept.
- CBSE 2026Set ANNUAL1 markQ.Fill in the blank: Depreciation is ________ in profit and loss account.
›Reveal solutionSolution
Answer: Debited in the Profit & Loss Account.
Depreciation is an expense (loss in the value of an asset used during the year), so it is debited to the Profit & Loss Account and deducted fro …
- CBSE 2026Set ANNUAL1 markQ.State whether True or False: Outstanding salary account is a personal account.
›Reveal solutionSolution
The statement is True.
Outstanding salary represents the persons (employees) to whom salary is due, so it is a representative perso …
- CBSE 2025Set MARCH1 markMCQQ.Outstanding rent is a/an :(a) Liability(b) Asset(c) Expense(d) Income
›Reveal solutionSolution
The correct answer is (a) Liability.
Under the accrual concept, an expense is recorded in the year it relates to, whether or not it is paid. "Outstanding rent" means rent for the current accounting year that has not yet been paid.
Its treatment:
Statement Treatment Profit & Loss Account Added to rent paid (to charge the full year's rent) - CBSE 2025Set ANNUAL1 markQ.Fill in the blank: Interest on Drawings is recorded in ________ side of profit and loss account.
›Reveal solutionSolution
Answer: Credit side.
Interest charged on a partner's/owner's drawings is a gain to the business, so it is recorded on the credit side of the Profit & Loss Account (and added to capita …
- CBSE 2025Set ANNUAL1 markQ.Fill in the blank: Expenses paid in current year, which are related to next year, is called ________.
›Reveal solutionSolution
Answer: Prepaid expenses.
An expense paid during the current year but whose benefit relates to the next year is a prepaid (unexpired) expense. It is deducted from the expe …
- CBSE 2024Set MARCH1 markQ.Prepaid expenses are assets of the business. (State True/False)
›Reveal solutionSolution
The statement is True.
A prepaid expense is an expense paid in advance for which the benefit has not yet been fully received (e.g. insurance paid for the next year). Since the business is entitled to that future benefit, it is shown as a current asset in the balan …
- CBSE 2023Set MARCH1 markMCQQ.Prepaid insurance is a/an ________ .(a) Asset(b) Liability(c) Expense(d) Revenue
›Reveal solutionSolution
Prepaid insurance is an asset (a current asset) — option (a).
From the Kerala Plus One (DHSE) Accountancy chapter Financial Statements – II (adjustments), under the accrual/matching concept:
- Prepaid (unexpired) expense = an expense paid in the current year whose benefit will be enjoyed in the next accounting period.
- Only the expired portion is charged to the current year's Profit & Loss A/c; the unexpired (prepaid) portion is carried forward. …
- CBSE 2023Set ANNUAL1 markMCQQ.Outstanding electricity charge is a/an(a) Artificial Personal Account(b) Real Account(c) Nominal Account(d) Representative Personal Account
›Reveal solutionSolution
Outstanding electricity charge is a Representative Personal Account.
Accounts are classified as Personal, Real and Nominal. Within personal accounts, a representative personal account stands for a person or group of persons indirectly — e.g. outstanding expenses, prepaid expenses, accrued income. 'Outstanding electricity charge' represents the amount still payable to the electricity authority, so it is a representative personal acc …
- CBSE 2023Set ANNUAL1 markMCQQ.Prepaid legal charge is a/an(a) Artificial Personal Account(b) Real Account(c) Nominal Account(d) Representative Personal Account
›Reveal solutionSolution
Prepaid legal charge is a Representative Personal Account.
A representative personal account represents a person or group indirectly. Prepaid (unexpired) expenses such as prepaid legal charges represent the party to whom payment has been made and from whom the benefit/service is still due, so they are treate …
- CBSE 2022Set MARCH1 markMCQQ.Statement of affairs is prepared to find out ________.(a) Capital(b) Net profit(c) Total assets(d) Total liabilities
›Reveal solutionSolution
A Statement of Affairs is prepared to find out Capital — option (a). Kerala Plus One (DHSE) Accountancy, Accounts from Incomplete Records.
Under incomplete records (single entry), proper ledger accounts and a capital account are not maintained, so capital cannot be read off directly. A Statement of Affairs is prepared — a rough balance sheet listing all known assets on one side and all known liabilities on the other. The difference is the capital:
Capital = Total Assets − Total Liabilities
…
- CBSE 2022Set ANNUAL1 markMCQQ.Outstanding office rent is a/an(a) expense(b) asset(c) income(d) liability
›Reveal solutionSolution
Outstanding rent = expense incurred but not paid; the unpaid amount owed to the landlord is a current liability.
- Under the accrual concept, rent for the period is charged as an expense to the Profit & Loss Account whether or not it is paid.
- The portion not yet paid (outstanding) is still owed by the business, so it is a current liability appearing on the liabilities side of the Balance Sheet. …
- CBSE 2022Set ANNUAL1 markMCQQ.Pre-paid insurance is a(a) Personal Account(b) Real Account(c) Nominal Account(d) Representative Personal Account
›Reveal solutionSolution
Prepaid insurance represents a future benefit already paid for; such representative balances are Representative Personal Accounts.
- A Representative Personal Account represents a person or group of persons indirectly — e.g. prepaid (unexpired) and outstanding items.
- Insurance paid in advance means the insurer owes the business future cover; the prepaid balance represents that party, so it is a Representative Personal Account. …
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