Matching principle

In accrual accounting, the matching principle dictates that an expense should be reported in the same period as the corresponding revenue is earned. The revenue recognition principle states that revenues should be recorded in the period in which they are earned, regardless of when the cash is transferred. By recognising costs in the period they are incurred, a business can determine how much was spent to generate revenue, thereby reducing discrepancies between when costs are incurred and when revenue is realised. In contrast, cash basis accounting requires recognising an expense when the cash is paid, irrespective of when the expense was incurred.^[1]

If no cause-and-effect relationship exists (e.g., a sale is impossible), costs are recognised as expenses in the accounting period in which they expired, i.e., when the product or service has been used up or consumed (e.g., spoiled, dated, or substandard goods, or services no longer needed). Prepaid expenses are not recognised as expenses but as assets until one of the qualifying conditions is met, which then results in their 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 provide probable future benefits. As a prepaid expense is used, an adjusting entry is made to update the value of the asset. For example, with prepaid rent, the cost for the period would be deducted from the Prepaid Rent account.^[2]

Expense vs. cash timing

Two types of balancing accounts exist to prevent fictitious profits and losses that might arise when cash is paid out in different accounting periods than when expenses are recognised. According to the matching principle in accrual accounting, expenses are recognised when obligations are incurred, regardless of when cash is paid. Cash can be paid out either before or after the obligations are incurred (when goods or services are received), leading to the following two types of accounts:

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

Accrued expenses are liabilities with uncertain timing or amount, but the uncertainty is not significant enough to classify them as a provision. An example is an obligation to pay for goods or services received, where cash is to be paid out in a later accounting period. The amount is deducted from accrued expenses when it is paid. Accrued expenses share characteristics with deferred income (or deferred revenue), except that deferred income involves cash received from a counterpart, while accrued expenses involve obligations to be settled later.

Deferred expenses (or prepaid expenses or prepayments) are assets, such as cash paid out for goods or services to be received in a later accounting period. When the promise to pay is fulfilled, the related expense item is recognised, and the same amount is deducted from prepayments. Deferred expenses share characteristics with accrued revenue (or accrued assets), but differ in that deferred expenses involve cash paid for future goods or services, while accrued revenue involves cash to be received for goods or services already delivered.

Examples

Accrued expense allows one to match future costs of products with the proceeds from their sales before paying out those costs.
Deferred expense (prepaid expense) allows one to match costs of products that have been paid for but not yet received.
Depreciation matches the cost of purchasing fixed assets with the revenues they generate by spreading these costs over their expected useful life.

Accrued expenses

For example, if goods are supplied by a vendor in one accounting period but paid for in a later period, this creates an accrued expense. This adjustment prevents a fictitious increase in the receiving company's value equal to the increase in its inventory (assets) by the cost of the goods received but not yet paid for. Without such an accrued expense, a sale of these goods in the period they were supplied would lead to unpaid inventory (recognized as an expense but not actually incurred) offsetting the sale proceeds (revenue). This would result in a fictitious profit in the sale period and a fictitious loss in the payment period, both equal to the cost of goods sold.

Period costs, such as office salaries or selling expenses, are immediately recognized as expenses and offset against revenues of the accounting period. Unpaid period costs are recorded as accrued expenses (liabilities) to ensure these costs do not falsely offset period revenues and create a fictitious profit. For example, if a sales representative earns a commission at the time of sale (or delivery) but is compensated in the following week, in the next accounting period, the company recognizes the commission as an expense in its current income statement to match the sale proceeds (revenue). The commission is recorded as accrued expenses in the sale period to prevent a fictitious profit. It is then deducted from accrued expenses in the subsequent period to prevent a fictitious loss when the representative is compensated.

Deferred expenses

A deferred expense (also known as a prepaid expense or prepayment) is an asset representing costs that have been paid but not yet recognized as expenses according to the matching principle.

For example, when accounting periods are monthly, an 11/12 portion of an annually paid insurance cost is recorded as prepaid expenses. Each subsequent month, 1/12 of this cost is recognized as an expense, rather than recording the entire amount in the month it was billed. The remaining portion of the cost, not yet recognized, stays as prepayments (assets) to prevent it from becoming a fictitious loss in the billing month and a fictitious profit in other months.

Similarly, cash paid for goods and services not received by the end of the accounting period is added to prepayments. This practice prevents the expense from being recorded as a fictitious loss in the payment period and as a fictitious profit in the period when the goods or services are received. The cost is not recognized in the income statement (also known as profit and loss or P&L) during the payment period but is recorded as an expense in the period when the goods or services are actually received. At that time, the amount is deducted from prepayments (assets) on the balance sheet.

Depreciation

Depreciation allocates the cost of an asset over its expected lifespan according to the matching principle. For example, if a machine is purchased for $100,000, has a lifespan of 10 years, and produces the same amount of goods each year, then $10,000 of the cost (i.e., $100,000 divided by 10 years) is allocated to each year. This approach avoids charging the entire $100,000 in the first year and none in the subsequent nine years. By matching costs to sales, depreciation provides a more accurate representation of the business's financial performance, although it creates a temporary discrepancy between profit or loss and the cash position of the business.

References

^ Accounting Principles by Wild, Shaw, Chiappetta
^ Libby, Robert; Libby, Patricia; Short, Daniel (2011). Financial Accounting. McGraw-Hill. p. 111. ISBN 978-0-07-768523-2.