Adjusting Entries for Prepaid Expenses, Accrued Revenue and Depreciation

What Are Adjusting Entries?

An adjusting entry is a journal entry recorded at the end of an accounting period to recognise income or expenses in the correct period. It also records the related asset, liability or reduction in an asset. The last day of the accounting period, usually 31 March for annual accounts in India, is called the reporting date.

Under section 128(1) of the Companies Act, 2013, companies must keep books on the accrual basis and use the double-entry system. Accounting Standard (AS) 1 also treats accrual as a fundamental accounting assumption, meaning revenue and costs are recognised when they are earned or incurred, not only when cash changes hands. 

Income-tax accounting is a separate question. Section 276 of the Income-tax Act, 2025 permits business income and income from other sources to be computed under the cash or mercantile (accrual) system regularly followed by the taxpayer. A company must still maintain its statutory books on the accrual basis.

The prepaid expense and income received in advance examples assume that the full amount was initially recorded as an expense or as income. The other examples below show how to record amounts not yet recognised or account for depreciation.

Prepaid Expenses

A prepaid expense is a payment made before the related benefit has been fully used. The unused portion remains an asset at the reporting date. Annual insurance, rent paid in advance and yearly software contracts are common examples.

Example: Annual Insurance Prepayment

A trader pays ₹36,000 on 1 November 2026 for a 12-month insurance policy and records the full amount as Insurance Expense. The amount excludes any recoverable GST.

• Monthly cost: ₹36,000 ÷ 12 = ₹3,000
• Cost used from November to March: ₹3,000 × 5 = ₹15,000
• Unused benefit on 31 March 2027: ₹36,000 − ₹15,000 = ₹21,000

The profit and loss account includes ₹15,000 as insurance expense for 2026-27. The balance sheet shows ₹21,000 as a prepaid asset. Charge the remaining ₹3,000 to expense each month as the policy benefit is used.

Keep a prepaid-expense schedule showing the supplier, service period, amount excluding recoverable tax, monthly charge and closing balance.

Outstanding Expenses

An outstanding expense, also called an accrued expense, is a cost incurred by the reporting date that has not yet been recorded. It creates an expense and a liability even though the supplier’s bill or payment comes later.

Example: March Electricity Cost

A business estimates that electricity used in March 2027 costs ₹14,500. The bill is received and paid on 8 April 2027. GST is ignored in this example.

The first entry places the cost in 2026-27, when the electricity was consumed. The second clears the liability when the bill is paid.

Accrued Income (Accrued Revenue)

Accrued income is income earned by the reporting date but not yet recorded. It includes completed work that has not been invoiced, interest earned but not received and commission earned but not billed.

Accrued income is not always the same as a trade receivable. A trade receivable is an amount the business has an unconditional right to collect, even if an invoice has not yet been issued. Schedule III of the Companies Act, 2013 sets the format for company financial statements. Companies must show unbilled dues separately where required and follow the applicable accounting standards for classification.

Example: Consulting Work Completed Before Billing

A consultant completes work worth ₹60,000 on 28 March 2027 and issues the invoice on 5 April 2027. Assume an illustrative GST rate of 18%, no earlier payment and a 30-day invoice deadline.

• GST: ₹60,000 × 18% = ₹10,800
• Invoice total: ₹60,000 + ₹10,800 = ₹70,800

The service income belongs to 2026-27 because the work was completed before 31 March 2027. GST follows its own timing rule. Under section 13 of the Central Goods and Services Tax Act, 2017, the time of supply for services depends on the invoice, payment and service dates. Because this invoice is issued within the prescribed period and no payment arrived earlier, output GST arises on the invoice date. Rule 47 of the Central Goods and Services Tax Rules, 2017 generally requires a service invoice to be issued within 30 days of the date of supply. Confirm the correct Services Accounting Code (SAC) and GST rate for the actual service.

Income Received in Advance

Income received in advance is money collected before the related goods or services have been supplied. The unearned amount is a liability because the business still owes the customer performance or, depending on the contract, a refund.

Example: Annual Maintenance Contract

A service business receives ₹24,000 plus GST at an illustrative rate of 18% on 1 January 2027 for a 12-month annual maintenance contract. The full service value is initially recorded as income.

• Monthly income: ₹24,000 ÷ 12 = ₹2,000
• Income earned from January to March: ₹2,000 × 3 = ₹6,000
• Unearned income on 31 March 2027: ₹24,000 − ₹6,000 = ₹18,000
• GST: ₹24,000 × 18% = ₹4,320
• Total received: ₹28,320

The profit and loss account includes ₹6,000 as income for 2026-27. The balance sheet shows ₹18,000 as a liability. A cleaner process is to record the service value as income received in advance when cash arrives, then recognise ₹2,000 as income each month.

For taxable services, section 13 of the Central Goods and Services Tax Act, 2017 generally makes GST payable when the advance is received, even though accounting income is recognised over the service period. Confirm the taxability, place of supply and rate before posting the entry.

Depreciation

Depreciation spreads the cost of a long-term physical asset over the years it is used. The total amount to be depreciated is generally the asset's cost minus its residual value (the amount expected at the end of its useful life). Depreciation records the cost of using the asset, not changes in its market price.

For companies, Schedule II of the Companies Act, 2013 provides standard useful lives for different assets. It also states that residual value should generally not exceed 5% of the asset's original cost. This is not a required residual value for every asset. Businesses should use an estimate that reflects what they expect to recover when they stop using the asset.

If a company uses a different depreciation period or a residual value above 5%, it must explain and support the decision. Accounting Standard (AS) 10 also requires businesses to review the asset’s useful life, residual value and depreciation method at the end of every financial year.

Common Depreciation Methods

Businesses generally use three methods to calculate depreciation:

• Straight-line method: Records an equal amount of depreciation each year over the asset's useful life, assuming estimates remain unchanged.
• Diminishing balance method: Calculates depreciation on the asset's remaining book value, so the yearly expense usually decreases.
• Units of production method: Calculates depreciation based on how much an asset is used or how many units it produces.

Depreciation applies to physical assets such as machinery and vehicles. Amortisation spreads the cost of intangible assets, such as patents and software licences with a limited useful life, over the periods they benefit.

Example: Book and Tax Depreciation

A company buys general plant and machinery for ₹6,00,000, excluding recoverable tax, and puts it to use on 1 April 2026.

• Schedule II useful life: 15 years
• Supported residual value: 5%, or ₹30,000
• Book method: Straight-line method
• Income-tax rate: 15% written down value (WDV)
• The tax block has no other additions, disposals or adjustments

Book depreciation:

(₹6,00,000 − ₹30,000) ÷ 15 = ₹38,000 per year

Illustrative tax depreciation:

• Year 1: ₹6,00,000 × 15% = ₹90,000
• Year 2: ₹5,10,000 × 15% = ₹76,500

The book entry on 31 March 2027 is:

Accumulated depreciation is the total depreciation recorded on an asset so far. It is deducted from the asset's cost to calculate its book value.

For tax purposes, similar assets are grouped into a block of assets, and depreciation is calculated for the group rather than each machine separately. This example uses a block containing one machine, with no other purchases or sales.

The Income-tax Rules, 2026 prescribe these common WDV rates:

Asset Put to Use During the Year

Schedule II requires depreciation on an addition to be calculated from the date of addition. If the same machine is put to use on 1 January 2027 and the company applies monthly proration consistently, book depreciation is:

₹38,000 × 3 ÷ 12 = ₹9,500

Under section 33(4) of the Income-tax Act, 2025, an asset acquired during the tax year (normally 1 April to 31 March) and used for less than 180 days receives 50% of the prescribed rate.

₹6,00,000 × 15% × 50% = ₹45,000

Tax and Compliance Checks Before Closing

Accounting recognition does not settle every tax question. Review these items before finalising the entries:

Period-End Workflow

1. Post routine sales, purchases, receipts, payments and journal entries.
2. Reconcile bank accounts, customer balances, supplier balances and tax ledgers.
3. Review contracts, invoices and service periods that cross the reporting date.
4. Prepare schedules for prepayments, outstanding expenses, unbilled income, customer advances and fixed assets.
5. Post each adjustment through a journal voucher dated at the reporting date.
6. Attach the source document, calculation and approval to the voucher or close file.
7. Review GST, TDS and income-tax effects separately.
8. Run the trial balance, profit and loss account and balance sheet again, then investigate every unexplained balance.

BUSY accounting software can bring journal vouchers, ledgers and period-end reports into one accounting workflow. Start a free trial or book a demo if your team wants to reduce spreadsheet-based closing work.

Conclusion

Adjusting entries make the closing accounts reflect what the business earned, used and owed during the period. Prepayments and accrued income create assets, while outstanding expenses and advance income create liabilities. Depreciation records the period’s use of long-term assets, with separate calculations for book and tax purposes. Before carrying balances forward, confirm that cut-off entries, supporting schedules and reconciliations are complete.