Accruals and prepayments explained

Accruals and prepayments are end-of-period adjustments that make sure every expense and income is recorded in the period it belongs to, not on the date cash changes hands. An accrued expense has been used but not yet paid, so it becomes a current liability, whereas a prepaid expense is paid in advance for a future period, so it becomes a current asset. Getting these two right lets you calculate true profit accurately.

The matching principle behind it

Both adjustments come from the matching principle, which says expenses must be matched against the income of the same period. If your shop used electricity to trade in December, that cost belongs to December even if the bill is only paid in January. Likewise, if you pay six months of rent at once, only the portion consumed within the accounting period counts as an expense. This principle is what requires accountants to adjust the books so that profit is not overstated or understated.

Accrual basis versus cash basis

Under the cash basis, expenses are recorded only when money leaves and income only when money arrives. It is simple but misleading, because profit then depends on payment timing rather than real activity. The accrual basis instead records expenses when they are incurred and income when it is earned, regardless of cash flow. Businesses use the accrual basis because it gives a fairer picture of performance. Accrued and prepaid expenses are the tools that convert raw cash figures into proper accrual figures.

Accrued expense as a liability

An accrued expense means the benefit has already been received but payment has not been made by the end of the period. Because the business still owes money to a supplier or service provider, the outstanding amount is recognised as a current liability in the statement of financial position. At the same time, the full expense for that period is included in the income statement. In other words, one entry increases the expense to reduce profit, and another creates an obligation to be settled later when payment is finally made.

Prepaid expense as an asset

A prepaid expense arises when payment is made in advance for a service not yet fully used. A common example is a one-year insurance premium paid halfway through the year. The portion that still covers a future period is not an expense of the current year; it represents a benefit not yet consumed, so it is recognised as a current asset. Only the portion already used during the period is charged as an expense. This asset gradually shrinks as time passes, until the benefit runs out and the whole amount becomes an expense.

Worked example: accrued expense

Suppose electricity costs RM300 a month and the financial year ends on 31 December. The December bill will only be paid in January, so on 31 December there is RM300 that has been incurred but not yet paid. In the income statement, the electricity expense is increased by RM300 so it covers all twelve months. In the statement of financial position, the same RM300 is recorded as an accrued expense under current liabilities. When the payment is made in January, that liability is cleared.

Worked example: prepaid expense

Say shop rent is RM1,200 a year, paid in one lump sum on 1 October for the twelve months ahead. By 31 December, only three months, or RM300, have been used. The remaining nine months, worth RM900, still cover the following year. So RM900 is removed from rent expense and shown as a prepaid expense within current assets. The rent expense in the income statement is only RM300. In the next year, that RM900 is transferred back into expense as its benefit is consumed.

Effect on net profit

These adjustments protect the accuracy of profit. If an accrued expense is ignored, total expenses are too low, so profit is reported higher than it should be. If a prepaid expense is not removed, expenses are too high, so profit is reported lower than it should be. Both errors produce a misleading profit figure for the owner and stakeholders. By adjusting expenses to the correct period, the income statement shows the results the business earned that year, unaffected by the coincidental date of payment.

Effect on the statement of financial position

Besides affecting profit, these adjustments also change the statement of financial position. An accrued expense adds to current liabilities because it is a short-term debt that must be settled soon. A prepaid expense adds to current assets because it is a benefit still to be used. Both must be matched so the accounting equation stays balanced: any change in accumulated profit must be offset by a change in assets or liabilities. This is why end-of-period adjustments are so often tested in pairs within one question.

Accrued income and income received in advance

The same logic applies to income. Accrued income is revenue that has been earned but not yet received, such as rent that should have arrived but a tenant paid late; it is recognised as a current asset. Income received in advance is revenue received but not yet earned, such as fees paid by a customer for next year's service; it becomes a current liability because the business still owes that service. Understanding both sides of income makes it much easier to prepare a complete set of adjustments.

Common mistakes to avoid

The most frequent slip is misplacing the item: an accrued expense wrongly shown as an asset, or a prepaid expense wrongly shown as a liability. Some students adjust the income statement but forget to enter the matching balance in the statement of financial position, leaving the figures out of balance. Another error is counting the number of months incorrectly when splitting a payment. The safest habit is to ask two simple questions each time: has the benefit been used, and has the money been paid.

How to get this topic right

Structured practice works better than memorising rules. Start by drawing a timeline marking the month it begins, the month the accounting period ends, and the portion consumed. Then write one sentence: how much has been used, and how much is still outstanding or prepaid. After that, make entries in both statements and check whether the statement of financial position balances. Repeat with different kinds of expense such as rent, salaries, interest and insurance, so the pattern of thinking becomes automatic.

Learn with 1-to-1 guidance

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FAQ

Is an accrued expense an asset or a liability? It is a current liability, because the business has already received the benefit but still owes the payment. The outstanding amount is settled in the next period when the supplier or service provider is paid.

Why is a prepaid expense treated as an asset? Because payment has been made for a benefit not yet fully used. The portion that still covers a future period represents value that can be enjoyed later, so it is recognised as a current asset until the benefit is consumed and becomes an expense.

How do these adjustments affect profit? An accrued expense increases expenses and therefore lowers the current year's profit, while a prepaid expense removes next year's expense and therefore raises the current year's profit. Both ensure the reported profit reflects real activity of the period, not merely the date of payment.