In accrual accounting, the matching principle states that expenses should be recorded during
the period in which they are incurred, regardless of when the transfer of cash occurs. Conversely,
cash basis accounting calls for the recognition of an expense when the cash is paid, regardless
of when the expense was actually incurred. If no cause-and-effect relationship exists,
costs are recognized as expenses in the accounting period they expired: i.e., when have been
used up or consumed. Prepaid expenses are not recognized as expenses, but as assets
until one of the qualifying conditions is met resulting in a recognition as expenses.
Lastly, if no connection with revenues can be established, costs are recognized immediately
as expenses. Prepaid expenses, such as employee wages or
subcontractor fees paid out or promised, are not recognized 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.
The matching principle allows for a more objective analysis of profitability. By recognizing
costs in the period they are incurred, a business can see how much money was spent to generate
revenue, reducing "noise" from timing mismatch between when costs are incurred and when revenue
is realized.
Expense vs. cash timing 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 latter period than obligations
are incurred and related expenses are recognized that results 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
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, and the same amount is deducted from deferred
revenues. Deferred expenses 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 actually acknowledged, the related expense item is
recognized, and the same amount is deducted from prepayments. It shares characteristics
with accrued revenue 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 and the related
revenue item is recognized, while cash for them is to be received in a later period,
when its amount is deducted from accrued revenues. Examples
Accrued expense allows one to match future costs of products with the proceeds from their
sales prior to paying out such costs. Deferred 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
life. Accrued expenses
For example, supplying goods in one accounting period by a vendor, but paying for them in
a later period results in an accrued expense that prevents a fictitious increase in the
receiving company's value equal to the increase in its inventory by the cost of the goods
received, but unpaid. Without such accrued expense, a sale of such goods in the period
they were supplied would cause that the unpaid inventory would effectively offset the sale
proceeds resulting in a fictitious profit in the period of sale, and in a fictitious
loss in the latter period of payment, both equal to the cost of goods sold.
Period costs, such as office salaries or selling expenses, are immediately recognized as expenses
also when employees are paid in the next period. Unpaid period costs are accrued expenses to
avoid such costs to offset period revenues that would result in a fictitious profit.
An example is a commission earned at the moment of sale by a sales representative who is compensated
at the end of the following week, in the next accounting period. The company recognizes
the commission as an expense incurred immediately in its current income statement to match the
sale proceeds, so the commission is also added to accrued expenses in the sale period to
prevent it from otherwise becoming a fictitious profit, and it is deducted from accrued expenses
in the next period to prevent it from otherwise becoming a fictitious loss, when the rep is
compensated. Deferred expenses
A Deferred expense is an asset used to costs paid out and not recognized as expenses according
to the matching principle. For example, when the accounting periods are
monthly, an 11/12 portion of an annually paid insurance cost is added to prepaid expenses,
which are decreased by 1/12 of the cost in each subsequent period when the same fraction
is recognized as an expense, rather than all in the month in which such cost is billed.
The not-yet-recognized portion of such costs remains as prepayments to prevent such cost
from turning into a fictitious loss in the monthly period it is billed, and into a fictitious
profit in any other monthly period. Similarly, cash paid out for goods and services
not received by the end of the accounting period is added to the prepayments to prevent
it from turning into a fictitious loss in the period cash was paid out, and into a fictitious
profit in the period of their reception. Such cost is not recognized in the income statement
as the expense incurred in the period of payment, but in the period of their reception when
such costs are recognized as expenses in P&L and deducted from prepayments on balance sheets.
Depreciation Depreciation is used to distribute the cost
of the asset over its expected life span according to the matching principle. If a machine is
bought for $100,000, has a life span of 10 years, and can produce the same amount of
goods each year, then $10,000 of the cost of the machine is matched to each year, rather
than charging $100,000 in the first year and nothing in the next 9 years. So, the cost
of the machine is offset against the sales in that year. This matches costs to sales
and therefore gives a more accurate representation of the business, but results in a temporary
discrepancy between profit/loss and the cash position of the business.
References ^ Accounting Principles by Wild, Shaw, Chiappetta
^ Libby, Robert; Libby, Patricia; Short, Daniel. Financial Accounting. McGraw-Hill. p. 111.
ISBN 978-0-07-768523-2. See also
Accrual Comparison of cash and accrual methods of
accounting Deferrals in accrual accounting
FIFO and LIFO accounting, different ways of matching stock to sales
Revenue recognition