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Matching principle |
Matching principle is a cornerstone of accrual accounting together with revenue recognition. They both determine the point, at which expenses and revenues are recognized. According to the principle, expenses are recognized when they are (1) incurred and (2) offset against recognized revenues, which were generated from those expenses (or related on the cause-and-effect basis), no matter when cash is paid out. In contrast, cash accounting records expenses, when cash is paid out no matter when obligations are incurred and regardless of revenues.
If no cause-and-effect relationship exists (e.g. no sale took place), costs are recognized as expenses in the accounting period when they used up or have expired (e.g. of spoiled, dated, substandard goods or not demended services). 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 (e.g. general administrative, selling and research and development costs).
For instance, worker wages or subcontractor fees paid out or promised are not recognized as expenses until the actual products are sold. When the products are sold, such obligations are recognized as cost of goods sold (expenses).
Matching principle allows better evaluation of actual profitability and performance (shows how much was spent to earn revenue), and reduces noise from timing mismatch between when costs are incurred and when revenue is realized.
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Accrued revenue (or accrued assets) is an asset earned for goods or services provided TO a counterpart, but not yet billed or paid for by him to become a revenue. It shares characteristics with prepaid expense (or deferred expense, or prepayment) with the difference that a disbursement TO a counterpart, who will bill latter, is not as the value of goods or services provided, but as cash paid out, which remain an asset until invoiced to become an expense.
Accrued expense, in contrast, is a liability with an uncertain timing or amount, but where the uncertainty is not significant enough to qualify it as a provision. It is incurred as the value of goods or services received FROM a counterpart, but not yet billed or paid for to become an expense. It shares characteristics with deferred income (or deferred revenue) with the difference that receipts FROM a counterpart to be billed latter are not as the value of goods or services, but as cash received, which remain a liability until invoiced to become a revenue.
Deferred expense (or prepaid expense, or prepayment) is an asset. It is recorded when a liability is recorded, but the related expense will be incurred only in the future. It shares characteristics with accrued revenue (or accrued assets) with the difference that a disbursement TO a counterpart to be billed latter is not as cash paid out, but as the value of goods or services provided, which remain an asset until invoiced to become an expense.
Deferred revenue (or deferred income) is a liability. It is recorded when an asset (e.g. receivable) is recorded, but the related income (i.e. revenue) will be earned only in the future. It shares characteristics with accrued expense with the difference that receipts FROM a counterpart, who will bill latter, are not as cash received, but as the value of goods or services received, which remain a liability until invoiced to become a revenue.
Accrued expenses are liabilities used to enable management according to matching principle of future costs with an uncertain timing or amount.
An example is that of a vendor supplying goods in one month, but billing in the following month. Without accrued expanses, if the goods are sold in the month they were supplied without invoice, no matching costs would be to record. No invoice costs to match the proceeds would result in a "fictitious" 100% profit in the month of sales, and, in the next month, in a "fictitious" loss equal to the invoice costs incurred when there are no matching sales.
Period costs, such as office salaries and selling expenses, are matched with the revenues (recorded) immediately, even though the employees may get paid in the next accounting period. E.g., a sales representative, who sold a product, earned a commission at the moment of sale (or delivery). The company will record the expense (commissions) in its current income statement, even though the rep will actually get paid at the end of the following week, in the next accounting period.
Deferred expenses (prepaid expenses) are assets used to enable management of costs paid out and not recognized as expenses according to matching principle. An example are these of insurance. Insurance costs are usually paid out on annual basis. So, if accounting periods are monthly, then only 1/12th of annual insurance costs is to be recognized as expense in each month rather than all in the month, in which such costs were billed. The not recognized portion of such costs remains as an asset within prepayments.
Similarly, costs that have been paid out for goods and services not received by the end of an accounting period are recorded as prepayments. These costs will not be recognized as expenses in Income Statement (Profit and Loss or P&L). When the goods or services are received, then such costs are recognized as expenses in P&L and deducted from prepayments (assets) on balance sheets.
Depreciation is used to apportion the cost of the asset over its expected lifespan according to matching principle. If you bought a machine for $100,000 and it has a life span of 10 years and it can produce the same amount of goods each year, you would match $10,000 of the cost of the machine to each year rather than charge $100,000 in the first year and nothing in the next 9 years. So when you sell items in each year you apportion a cost of the machine against the sales in that year. This matches costs to sales.
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