Under the accruals (matching) concept, expenses and income belong to the period they relate to — not the period they happen to be paid or received. Year-end adjustments correct this.
The four adjustments
| Item | Adjust the account by… | Balance sheet |
|---|---|---|
| Accrued expense | Add to the expense | Current liability |
| Prepaid expense | Subtract from the expense | Current asset |
| Accrued income | Add to the income | Current asset |
| Prepaid income | Subtract from the income | Current liability |
Expense for the year
$\text{Expense} = \text{Paid} + \text{Accrued at end} - \text{Prepaid at end}$Also reverse last year's adjustments: subtract the opening accrual, add the opening prepayment.
Worked example
Rent paid during the year is $12{,}000$, and $1{,}000$ of rent is still owing at year-end. Rent expense $= 12{,}000 + 1{,}000 = 13{,}000$, and the $1{,}000$ owing is a current liability.
Exam tips
- Accrued expense and prepaid income are both liabilities.
- Prepaid expense and accrued income are both assets.
- Adjust the income statement first, then carry the balance to the balance sheet.