In accrual accounting, the matching principle instructs that an expense should be reported in the same period in which the corresponding revenue is earned. The revenue recognition principle states that revenues should be recorded during the period in which they are earned, regardless of when the transfer of cash occurs. By recognising costs in the period incurred, a business can see how much money was spent to generate revenue, reducing "noise" from the mismatch between when costs are incurred and when revenue is realised. Conversely, cash basis accounting calls for recognising an expense when the cash is paid, regardless of when the expense was incurred.^[1]

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If no cause-and-effect relationship exists (e.g., a sale is impossible), costs are recognised as expenses in the accounting period they expired i.e. when the product/service have been used up or consumed (e.g., of spoiled, dated, or substandard goods, or not demanded services). Prepaid expenses are not recognised as expenses but as assets until one of the qualifying conditions is met, resulting in a recognition as expenses. If no connection with revenues can be established, costs are recognised immediately as expenses (e.g., general administrative and research and development costs).

Prepaid expenses, such as employee wages or subcontractor fees paid out or promised, are not recognised as expenses. They are considered assets because they will provide probable future benefits. As a prepaid expense is used, an adjusting entry is made to update the value of the asset. In the case of prepaid rent, for instance, the cost of rent for the period would be deducted from the Prepaid Rent account.^[2]

Two types of balancing accounts exist to avoid fictitious profits and losses that might otherwise occur when cash is paid out not in the same accounting periods as expenses are recognized, because expenses are recognized when obligations are incurred regardless when cash is paid out according to the matching principle in accrual accounting. Cash can be paid out in an earlier or later period than obligations are incurred (when goods or services are received), and related expenses are recognized that result in the following two types of accounts:

• Accrued expense: Expense is recognized before cash is paid out.
• Deferred expense: Expense is recognized after cash is paid out.

Accrued expenses is a liability with an uncertain timing or amount, but where the uncertainty is not significant enough to qualify it as a provision. An example is an obligation to pay for goods or services received from a counterpart, while cash for them is to be paid out in a later accounting period when its amount is deducted from accrued expenses. It shares characteristics with deferred income (or deferred revenue) with the difference that a liability to be covered latter is cash received from a counterpart, while goods or services are to be delivered in a latter period, when such income item is earned, the related revenue item is recognized. The same amount is deducted from deferred revenues.

Deferred expenses (or prepaid expenses or prepayment) is an asset, such as cash paid out to a counterpart for goods or services to be received in a latter accounting period when fulfilling the promise to pay is acknowledged, the related expense item is recognized, and the same amount is deducted from prepayments. It shares characteristics with accrued revenue (or accrued assets) with the difference that an asset to be covered latter are proceeds from a delivery of goods or services, at which such income item is earned. The related revenue item is recognized, while cash for them is to be received later when its amount is deducted from accrued revenues.

• Accrued expense allows one to match future costs of products with the proceeds from their sales before paying out such costs.
• Deferred expense (prepaid expense) allows one to match costs of products paid out and not received yet.
• Depreciation matches the cost of purchasing fixed assets with revenues generated by them by spreading such costs over their expected useful life span.