ACCT1101 Chap.5 Accrual Accounting and the Matching Principle
Accrual Accounting and the Matching Principle
Under the accrual basis income belongs to the period it was earned in, and an expense to the period it was incurred in. The cash basis waits for the money in both cases.
Reporting entities are required to use the accrual basis, and the reason is accuracy: under the cash basis a business could improve this period's reported result simply by delaying a payment, which tells a reader nothing about how the business actually traded.
Earned has a definition that depends on what is being sold.
A manufacturer or retailer has earned its revenue once the goods reach the customer, whether or not anything has been paid. A service business has earned it once the work is done. A cost counts as incurred once the business owes it, whatever the payment date turns out to be.
The matching principle then pairs the two: expenses are recognised in the period whose income they helped generate, which is why the cost of goods sold appears in the same period as the sale rather than in the period the stock was bought.
Because the two triggers can fall in different periods, there are exactly four timing mismatches to know.
Accrued income is earned but not yet received, so income and a receivable both rise. Unearned income is received but not yet earned, so cash and a liability rise and no income is recognised. An accrued expense is incurred but unpaid, so an expense and a payable rise.
A prepayment is paid but not yet consumed, so cash falls and an asset rises with no expense at all.
The practical consequence is the one worth carrying into every later topic: under accrual accounting profit is rarely ever equal to cash flow, and neither figure is the wrong one. They answer different questions, which is why the course reports both.
What this chapter covers
- 01
Earned against received and incurred against paid
- 02
Why reporting entities are required to use the accrual basis
- 03
When revenue is earned for goods against for services
- 04
The matching principle and the period an expense belongs to
- 05
Accrued income and unearned income
- 06
Accrued expenses and prepayments
- 07
Why profit and cash flow rarely agree, and why neither is wrong
Sorting four events into recognised and not recognised
- +1The school invoice is accrued income: the sessions were delivered, so the income is earned in March whatever the payment date. Recognise $4,800 of income and a $4,800 receivable. Delivery, not the invoice date and not the payment date, is the trigger.
- +1The family's prepayment is partly earned. Three lessons of twelve is one quarter, so $7,200 times three twelfths gives $1,800 of income in March and a remaining liability of $5,400 as unearned revenue. The other nine lessons are still owed to the customer.
- +1The two costs go opposite ways. The electricity was consumed in March, so $610 is an expense in March and a payable, even though nothing has been paid. The insurance covers the three months after balance date, so none of it is a March expense; $2,400 is a prepaid asset.
Key terms
- Accrual accounting
- Recognising income when earned and expenses when incurred, regardless of when the related cash is received or paid.
- Cash accounting
- Recognising income and expenses only when cash is received or paid, which is simpler but allows reported performance to be shifted by timing.
- Matching principle
- Recognising an expense in the period whose income it helped to generate rather than the period it was paid in.
- Accrued income
- Work already done or goods already delivered that no money has arrived for, carried as income and a receivable.
- Unearned revenue
- Cash received before the goods or service are supplied, recorded as a liability until the obligation is discharged.
Accrual Accounting and the Matching Principle FAQ
If cash accounting is simpler, why is it not allowed for reporting entities?
Because it lets timing stand in for performance. A business could hold back payments until after balance date and report a better result without anything about its trading having changed. Accrual accounting ties recognition to the underlying event, so the reported figures describe what the business did rather than when it chose to move money.
When exactly is revenue earned on a credit sale?
When the goods are delivered to the customer or the service is performed, not when the customer pays and not when the invoice is issued. The receipt of cash later simply converts the receivable into cash, with no effect on income at all. That is why a business can report a profitable month and receive almost no money in it.
Do the four timing mismatches ever overlap?
They can appear together in one question but never in one item. Any single item is either cash first or service first, and either on the income side or the expense side, which is what gives you the four combinations. Deciding those two questions in order, cash or service first, then income or expense, fixes the answer before you write anything.
Exam move
Practise classification separately from calculation. Write twenty one line scenarios on cards, and for each one answer only two questions: did the cash move first or second, and is this income or expense. Do not compute anything. The classification is what the marks are for, and the arithmetic that follows is trivial once the branch is right.
Then rehearse the fraction.
Most of these questions release part of a prepaid or unearned amount, and the release is always measured in whatever unit the promise was written in. Months, lessons, matches and deliveries all appear, and questions deliberately supply more than one of them to see which you use.
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