Accruals and prepayments (the Matching Concept) (AS Level) Financial accounting

  

The goal of this process is to ensure that the Income Statement accurately reflects the business's performance for the period covered, irrespective of when cash was actually exchanged.

 The Matching Concept (Accruals Concept)

The Matching Concept is a fundamental accounting principle designed to provide reliable financial information.

Its core mandate is twofold:

1. Revenue Alignment: Ensure revenue and other income are accurately related to the period covered by the financial statements.
2. Expense Alignment: Ensure that expenses are matched to the revenue earned. This means expenses should be recorded in the Income Statement as they have been incurred, rather than when they have been paid.

The practical application of this concept involves using accruals and prepayments to adjust ledger balances at the end of the accounting period.

 Definitions of Accruals and Prepayments

Term	Definition	SFP Classification
Accrual (Accrued Expense)	An expense that has been incurred but not paid for (e.g., an unpaid electricity bill, where consumption has occurred).	Current Liability (collectively known as "other payables").
Prepayment (Prepaid Expense)	A payment made in advance of the benefits to be derived from it (e.g., rent paid for the following period).	Current Asset (collectively known as "other receivables").

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 Accounting Treatment for Expenses

The matching principle requires that expense accounts show only the cost incurred for the current accounting period, leading to the following entries in the ledger accounts and final statements:

1. Accrued Expense (Expense Owing)

An accrued expense represents an amount owed to an external party, making that party a creditor of the business.

• In the Ledger: The amount owing is inserted as a balancing figure (e.g., "Electricity owing") and shown as a credit balance carried down (c/d) on the expense account. This credit balance is then brought down (b/d) at the start of the next period.
• In the Income Statement: The expense account is debited with the full cost incurred for the year, even if only a partial amount has actually been paid.
• In the Statement of Financial Position (SFP): The balance brought down is shown under current liabilities as an "accrued expense," "expense creditor," or "other payables".

2. Prepaid Expense (Expense Paid in Advance)

A prepaid expense represents money paid for a benefit yet to be received; the person paid in advance is a debtor of the business.

• In the Ledger: The amount paid in advance is inserted as a balancing figure and shown as a debit balance carried down (c/d) on the expense account. This debit balance is brought down (b/d) at the start of the next period.
• In the Income Statement: The prepayment is deducted from the total cash paid to show only the portion of the expense relating to the current period.
• In the Statement of Financial Position (SFP): The balance brought down (b/d) is shown under current assets as an "other receivable".

 Accounting Treatment for Income

The same principle applies to income (such as rent or interest receivable), ensuring only income earned within the period is reported:

Type of Income Adjustment	SFP Classification	Income Statement Treatment
Accrued Income (Income due but not received)	Current Asset ("other receivable" or debtor).	Added to the income amount in the trial balance to show the full amount earned.
Prepaid Income (Income received in advance)	Current Liability ("other payable" or creditor).	Deducted from the income amount in the trial balance to remove the portion not yet earned.

 Accounting for Consumable Inventory

The matching concept dictates the treatment of inventories of consumable stores (e.g., stationery, heating fuel):

• If these items are unused at the year-end, they should not be charged as an expense against the current year's profit because they have not yet been consumed.
• Instead, they are treated as an asset. They are carried down as a debit balance (c/d) on the expense account and subsequently shown under current assets in the Statement of Financial Position.

 Adjusting the Trial Balance

When financial statements are prepared, the amounts for accruals and prepayments are used to adjust the figures that originally appear in the trial balance.

Item	Effect on Income Statement	Effect on Statement of Financial Position (SFP)
Accrued Expense	Add to the expense amount (increasing total expense).	Show as other payable under current liabilities.
Prepaid Expense	Deduct from the expense amount (reducing total expense).	Show as other receivable under current assets.
Accrued Income	Add to the income amount.	Show as other receivable under current assets.
Prepaid Income	Deduct from the income amount.	Show as other payable under current liabilities.

If no adjustments were made for accrued expenses, the profit for the year would be overstated and current liabilities would be understated.