There are two types of expenses: Cost of sales (the cost price of inventory that has been sold) and Other expenses (operating costs such as salaries, utilities, and rent). Under the matching theory, expenses must be matched against the revenue earned in the same accounting period to determine profit for the period.
Cost of sales is read directly from the ledger account balance. All expense accounts are closed at year end by debiting Income summary and crediting the specific expense account.
Expense payable arises when an expense has been incurred (used) but not yet paid by year end. It is a current liability. The year-end entry is Dr [Expense] / Cr [Expense] payable; the reversal is made on the first day of the new period. If omitted: expense is understated → profit is overstated.
Prepaid expense arises when an expense has been paid but not yet used by year end. It is a current asset. The year-end entry is Dr Prepaid [Expense] / Cr [Expense]; the reversal is made on the first day of the new period. If omitted: expense is overstated → profit is understated.
In the Statement of Financial Performance, the trading section is Net sales revenue − Cost of sales = Gross profit; other expenses are deducted after other income. The figures shown are the adjusted amounts — not the cash paid during the year. In the Statement of Financial Position, prepaid expenses appear as current assets; expense payables appear as current liabilities.
When interpreting an expense ledger account: a credit at the start of the year = reversal of previous year's payable; a credit near year end (before closing) = the unused portion recorded as prepaid expense; a debit near year end (before closing) = the unpaid portion recorded as expense payable; the closing credit (to Income summary) = the expense recognised for the period. The expense for the period is always the closing entry amount, not total cash paid.