For many businesses, transactions are considered recognized when cash is paid, such as when a check is sent to pay the utility bill. The cash method of accounting recognizes expenses when cash is paid, regardless of when the expense was incurred; conversely, the accrual method of accounting calls for expenses to be recorded during the period they incurred, regardless of the date of cash transfer. Businesses operating under the latter method find cause and effect relationships between specific expenses and the revenue they helped to earn.
The Difference: Period and Product Costs
Prior to understanding the differences in accounting for expenses, business owners should become familiar with the difference between period and product costs. As the two general types of costs associated with accounting transactions, period and product costs differentiate based on their ability to be directly associated with products and, in turn, revenues. Product costs can be matched directly with particular products (such as raw materials or direct labor), and thereby revenues, allowing the business an opportunity to record the transaction based upon the accrual method of accounting; period costs cannot be matched directly to a product or revenue stream (such as administrative salaries, office expenses, etc.), defaulting the business to expensing these costs within the current period.
The Matching Principle
Referred to as the matching principle, this method of accounting for expenses within the same accounting period as the revenues they helped to earn ensures that financial statements fairly measure the historical transaction information applicable to the business. As a statute of generally accepted accounting principles (GAAP), the matching principle is an extension of the revenue recognition convention, which states that revenues be recognizes at the time the transaction is completed regardless of when cash is received. For both the business owner and other users of the financial statements, the matching principle provides a more objective viewpoint to analyze profitability.
While simple in nature, the matching principle can be easily misinterpreted and applied erroneously in the accounting record. The following examples correctly apply the matching principle per GAAP standard:
- A business employs salespeople who earn commission based on a percentage of total sales for each month. Once commission is calculated the following month, the salespeople receive a check from the business in the amount earned; however, the commission expense incurred by the business is recorded as of the month it was earned.
- A manufacturing corporation processes raw goods into finished products, which are then sold. Upon the sale of each item, the cost of goods sold expense is recorded related to the item.
- A transportation business maintains multiple delivery trucks, which were in new condition at the time of purchase. Each month, an entry is made to allocate a portion of each delivery truck’s value to depreciation expense, thereby expensing the asset’s cost over the life of the asset.