Accruals and Prepayments: Conquering the Matching Principle

By Prof. Arthur Pendelton, Chartered Accountant·Updated April 18, 2026
A ledger demonstrating how prepaid insurance is transferred out of the profit calculation for the current accounting year.

How do I adjust expenses in the Income Statement?

Before transferring an expense (like Rent) from the Trial Balance to the Income Statement, you must adjust it. If there is an Accrued Expense at the end of the year, ADD it to the trial balance figure (because you owe it for this year). If there is a Prepaid Expense at the end of the year, SUBTRACT it from the trial balance figure (because it belongs to next year).

Table of Contents

Year-end adjustments are guaranteed to feature in Paper 2. Examiners will always give you a Trial Balance that is "wrong" because cash was paid at the wrong time. This guide from our Ultimate O-Level Accounting Guide gives you the exact rules to fix these figures before drafting the Income Statement.

1. The Golden Matching Principle

The entire concept of Accruals and Prepayments exists exclusively because of one accounting rule: The Matching Principle (or Accruals Concept).

This rule dictates that when calculating profit for the year 2025, you are ONLY allowed to include expenses that actually occurred in 2025. You must 'match' the 2025 revenue against the 2025 expenses. It does not matter when the physical cash was paid. Cash paid in 2025 for a 2026 expense must be completely removed from the 2025 calculation.

2. Accruals (Arrears): Owe it, ADD it.

An Accrual is an expense relating to the current accounting year that has not been paid yet. (Sometimes exams refer to this as a cost 'in arrears').

Example:

The Trial Balance shows electricity paid as $10,000. However, the notes say $1,000 of electricity was used in December but the bill hasn't been paid yet.

The Income Statement Fix:

Did we use the electricity this year? Yes. Does it belong to this year's profit calculation? Yes. Therefore, you must ADD the $1,000 accrual to the $10,000.
Income Statement Electricity Expense = $11,000.

3. Prepayments: Paid early, SUBTRACT it.

A prepayment is cash you paid out during this year, but it actually relates to a service you will receive NEXT year.

Example:

The Trial Balance shows Insurance paid as $12,000. The notes say $2,000 of this payment covers January and February of NEXT year.

The Income Statement Fix:

Does the $2,000 relate to this year? No. It breaks the matching principle. You must SUBTRACT the $2,000 prepayment from the $12,000.
Income Statement Insurance Expense = $10,000.

4. The Statement of Financial Position Impact

When you adjust the Income Statement, the double-entry rule demands you must also adjust the Statement of Financial Position (SOFP). Every accrual and prepayment must be listed as an Asset or Liability.

Accrued Expenses = Current Liability

We used the electricity, but we haven't paid the electricity company yet. We legally OWE them money. Any debt we owe to a third party to be paid in the next 12 months is always a Current Liability.

Prepaid Expenses = Current Asset

We paid the insurance company early. They OWE US the insurance coverage. Because someone owes the business a service (or a refund), it is legally owned by the business. It is a Current Asset.

Prof. Arthur Pendelton📋 From the Desk of Prof. Arthur Pendelton
The Accrued Income Trap: Exams occasionally reverse the logic by asking about Accrued INCOME (e.g., a tenant owes us rent but hasn't paid us yet). Do not get confused! If someone owes US money, it is a Current Asset. If an income is Prepaid to us (a tenant pays rent in advance), we owe them the service, making it a Current Liability!

Frequently Asked Questions

What is the Matching Principle?▼
The rule stating income and expenses must be recorded in the specific year they apply to, completely ignoring when the physical cash was transferred.
What is an Accrual (Accrued Expense)?▼
A cost incurred this year that has not yet been paid. Added to the Income Statement, and recorded as a Current Liability.
What is a Prepayment (Prepaid Expense)?▼
An expense paid in advance for next year. Subtracted from the Income Statement, and recorded as a Current Asset.
How does an Accrual affect the Income Statement?▼
It is ADDED to the trial balance expense figure to ensure the total profit calculation accurately reflects all costs incurred this year.

Stop Guessing, Start Scoring

Get instant access to 500+ CAIE-aligned practice questions, worked solutions, and AI-powered mock exams across all O-Level subjects.

Access the Study Portal →Prepare with the Oracle Engine

Related Accounting Articles