Matching principle
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In
If no cause-and-effect relationship exists (e.g., a sale is impossible), costs are recognised as expenses in the
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]
Expense vs. cash timing
Two types of balancing
- Accrued expense: Expense is recognized before cash is paid out.
- Deferred expense: Expense is recognized after cash is paid out.
Accrued expenses is a
Deferred expenses (or prepaid expenses or prepayment) is an
Examples
- Accrued expenseallows 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.
Accrued expenses
For example, goods supplied by a vendor in one accounting period, 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 (assets) 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 the unpaid inventory (recognized as an expense fictitiously incurred) to effectively offset the sale proceeds (revenue), 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
Deferred expenses
A
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 (assets) 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 (the cost of) goods and services not received by the end of the
Depreciation
Depreciation distributes the asset's cost 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 (i.e. $100,000/10 years) of the machine is matched to each year, rather than charging $100,000 in the first year and nothing in the next 9 years. 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
- 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