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In
accrual accountingAccrual (''accumulation'') of something is, in finance, the adding together of interest or different investments over a period of time. It holds specific meanings in accounting, where it can refer to accounts on a balance sheet that represent liabili ...
, the matching principle instructs that an expense should be reported in the same period in which the corresponding revenue is earned, and is associated with
accrual accountingAccrual (''accumulation'') of something is, in finance, the adding together of interest or different investments over a period of time. It holds specific meanings in accounting, where it can refer to accounts on a balance sheet that represent liabili ...
and the revenue recognition principle states that revenues should be recorded during the period in which they are earned, regardless of when the transfer of cash occurs. 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. Conversely,
cash basis accounting A basis of accounting is the time various financial transactions are recorded. The cash basis (EU VAT vocabulary ''cash accounting'') and the accrual basis are the two primary methods of tracking income and expenses in accounting. Both can be ...
calls for the recognition of an expense when the cash is paid, regardless of when the expense was actually incurred.Accounting Principles by Wild, Shaw, Chiappetta If no cause-and-effect relationship exists (''e.g.,'' a sale is impossible), costs are recognized as expenses in the
accounting period An accounting period, in bookkeeping Bookkeeping is the recording of financial transactions, and is part of the process of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non fin ...
they expired: ''i.e.,'' when have been used up or consumed (''e.g.,'' of spoiled, dated, or substandard goods, or not demanded services). Prepaid expenses are not recognized as expenses, but as
asset In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such a ...
s 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 and research and development costs). Prepaid expenses, such as employee wages or subcontractor fees paid out or promised, are not recognized as expenses; they are considered
asset In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such a ...
s 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.{{cite book , last1=Libby , first1=Robert , last2=Libby , first2=Patricia , last3=Short , first3=Daniel , title=Financial Accounting , url=http://highered.mcgraw-hill.com/sites/0073526886/information_center_view0/ , year=2011 , publisher=McGraw-Hill , isbn=978-0-07-768523-2 , page=111


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 period An accounting period, in bookkeeping Bookkeeping is the recording of financial transactions, and is part of the process of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non fin ...
s as
expensesExpenditure is an outflow of money Image:National-Debt-Gillray.jpeg, In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with the beggar whose legs and arms were amputated, in the left corner, 174 ...
are recognized, because expenses are recognized when obligations are incurred regardless when cash is paid out according to the matching principle in
accrual accountingAccrual (''accumulation'') of something is, in finance, the adding together of interest or different investments over a period of time. It holds specific meanings in accounting, where it can refer to accounts on a balance sheet that represent liabili ...
. Cash can be paid out in an earlier or later period than obligations are incurred (when goods or services are received) 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 Liability may refer to: Law * Legal liability, in both civil and criminal law ** Public liability, part of the law of tort which focuses on civil wrongs ** Product liability, the area of law in which manufacturers, distributors, suppliers, retai ...
with an uncertain timing or amount, but where the uncertainty is not significant enough to qualify it as a
provision Provision may refer to: * Provision (accounting), a term for liability in accounting * Provision (contracting), a term for a procurement condition * Provision (album), ''Provision'' (album), an album by Scritti Politti See also

* Provisioning ...
. 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 An accounting period, in bookkeeping Bookkeeping is the recording of financial transactions, and is part of the process of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non fin ...
when its amount is deducted from ''accrued expenses''. It shares characteristics with
deferred incomeDeferred income (also known as deferred revenue, unearned revenue, or unearned income) is, in Accounting methods#Accrual basis, accrual accounting, money received for goods or services which has not yet been earned. According to the revenue recogniti ...
(or ''deferred revenue'') 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 In accounting Accounting or Accountancy is the measurement ' Measurement is the number, numerical quantification (science), quantification of the variable and attribute (research), attributes of an object or event, which can be used to comp ...
item is recognized, and the same amount is deducted from ''deferred revenues''. Deferred expenses (or prepaid expenses or prepayment) is an
asset In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such a ...
, such as cash paid out TO a counterpart for goods or services to be received in a latter
accounting period An accounting period, in bookkeeping Bookkeeping is the recording of financial transactions, and is part of the process of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non fin ...
when fulfilling the promise to pay is actually acknowledged, the related
expenseExpenditure is an outflow of money, or any form of Wealth, fortune in general, to another person or group as payment for an item, service, or other category of costs. For a leasehold estate, tenant, renting, rent is an expense. For students or parent ...
item is recognized, and the same amount is deducted from ''prepayments''. It shares characteristics with accrued revenue (or ''accrued assets'') 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 In accounting Accounting or Accountancy is the measurement ' Measurement is the number, numerical quantification (science), quantification of the variable and attribute (research), attributes of an object or event, which can be used to comp ...
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 (prepaid expense) allows one to match costs of products paid out and not received yet. *
Depreciation In accountancy, depreciation refers to two aspects of the same concept: first, the actual decrease of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wear, and second, the allocation in a ...

Depreciation
matches the cost of purchasing fixed
asset In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such a ...
s with revenues generated by them by spreading such costs over their expected life.


Accrued expenses

For example, goods supplied by a vendor in one
accounting period An accounting period, in bookkeeping Bookkeeping is the recording of financial transactions, and is part of the process of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non fin ...
, 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 Inventory (American English American English (AmE, AE, AmEng, USEng, en-US), sometimes called United States English or U.S. English, is the set of varieties of the English language native to the United States. Currently, American English ...
(
asset In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such a ...
s) 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 (recognized as an
expenseExpenditure is an outflow of money, or any form of Wealth, fortune in general, to another person or group as payment for an item, service, or other category of costs. For a leasehold estate, tenant, renting, rent is an expense. For students or parent ...
fictitiously incurred) would effectively offset the sale proceeds (
revenue In accounting Accounting or Accountancy is the measurement ' Measurement is the number, numerical quantification (science), quantification of the variable and attribute (research), attributes of an object or event, which can be used to comp ...
) 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
expensesExpenditure is an outflow of money Image:National-Debt-Gillray.jpeg, In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with the beggar whose legs and arms were amputated, in the left corner, 174 ...
(and offset against
revenues In accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such as businesses and corporations. Accounting, which has been calle ...
of the
accounting period An accounting period, in bookkeeping Bookkeeping is the recording of financial transactions, and is part of the process of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non fin ...
) also when employees are paid in the next period. Unpaid period costs are ''accrued expenses'' (liabilities) to avoid such costs (as expenses fictitiously incurred) to offset period revenues that would result in a fictitious profit. An example is a commission earned at the moment of sale (or delivery) 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
expenseExpenditure is an outflow of money, or any form of Wealth, fortune in general, to another person or group as payment for an item, service, or other category of costs. For a leasehold estate, tenant, renting, rent is an expense. For students or parent ...
incurred immediately in its current
income statement An income statement or profit and loss accountProfessional English in Use - Finance, Cambridge University Press, p. 10 (also referred to as a ''profit and loss statement'' (P&L), ''statement of profit or loss'', ''revenue statement'', ''statemen ...
to match the sale proceeds (revenue), 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 (''prepaid expenses'' or ''prepayment'') is an
asset In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such a ...
used to costs paid out and not recognized as expenses according to the matching principle. For example, when the
accounting period An accounting period, in bookkeeping Bookkeeping is the recording of financial transactions, and is part of the process of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non fin ...
s are monthly, an 11/12 portion of an annually paid
insurance Insurance is a means of protection from financial loss. It is a form of risk management Risk management is the identification, evaluation, and prioritization of risk In simple terms, risk is the possibility of something bad happening. ...

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
expenseExpenditure is an outflow of money, or any form of Wealth, fortune in general, to another person or group as payment for an item, service, or other category of costs. For a leasehold estate, tenant, renting, rent is an expense. For students or parent ...
, 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
accounting period An accounting period, in bookkeeping Bookkeeping is the recording of financial transactions, and is part of the process of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non fin ...
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 An income statement or profit and loss accountProfessional English in Use - Finance, Cambridge University Press, p. 10 (also referred to as a ''profit and loss statement'' (P&L), ''statement of profit or loss'', ''revenue statement'', ''statemen ...
(''profit and loss'' or P&L) as the
expenseExpenditure is an outflow of money, or any form of Wealth, fortune in general, to another person or group as payment for an item, service, or other category of costs. For a leasehold estate, tenant, renting, rent is an expense. For students or parent ...
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 (assets) on
balance sheet In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such a ...

balance sheet
s.


Depreciation

Depreciation In accountancy, depreciation refers to two aspects of the same concept: first, the actual decrease of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wear, and second, the allocation in a ...

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 (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. 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


See also

*
Accrual Accrual (''accumulation'') of something is, in finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments ...
*
Comparison of cash and accrual methods of accounting A basis of accounting is the time various financial transactions are recorded. The cash basis (EU VAT vocabulary ''cash accounting'') and the accrual basis are the two primary methods of tracking income and expenses in accounting. Both can be ...
*
Deferral A deferral, in ''accrual accountingAccrual (''accumulation'') of something is, in finance, the adding together of interest or different investments over a period of time. It holds specific meanings in accounting, where it can refer to accounts ...
s in accrual accounting *
FIFO and LIFO accounting FIFO and LIFO accounting are methods used in managing inventory Inventory (American English American English (AmE, AE, AmEng, USEng, en-US), sometimes called United States English or U.S. English, is the set of varieties of the English lan ...
, different ways of matching stock to sales *
Revenue recognition The revenue recognition principle is a cornerstone of accrual accounting together with the matching principle In accrual accounting, the revenue recognition principle states that revenues should be recorded during the period in which they are e ...
Expense Accounting terminology