Accrual accounting and the matching principle

Key takeaways

• Accrual accounting records revenue when earned and expenses when incurred; cash basis records both only when cash moves.
• The matching principle places expenses in the same period as the revenue they helped produce, or in the period they are consumed.
• Four adjustments bridge cash and accrual: accrued revenue and prepaid expenses create assets; accrued expenses and deferred revenue create liabilities.
• Accrual profit converts to cash profit by reversing the change in each accrual and deferral balance, which is exactly the working capital section of the cash flow statement.
• Deferred revenue is cash already collected for work not yet done: a liability on the balance sheet but often a sign of a healthy business model.
• Management judgment in timing accruals is the most common place earnings are shaped, so diligence tests accruals against cash.

Cash basis and accrual basis

Under the cash basis, revenue is the cash received from customers in the period and expenses are the cash paid out. There are no receivables, no payables and usually no depreciation. It is simple, it cannot be manipulated by estimates, and it tells you exactly how much money came and went. Many very small businesses keep their books this way, and some tax regimes allow or require it for small taxpayers.

Under the accrual basis, revenue is recognized when the company has delivered the goods or services it promised, and expenses are recognized when the company consumes the resource, whether or not cash has changed hands. This creates balance sheet accounts that hold the timing differences: receivables for revenue earned but not collected, payables and accrued liabilities for expenses incurred but not paid, deferred revenue for cash collected before the work is done, and prepaid expenses for cash paid before the resource is used.

The point of the accrual basis is comparability over time. Cash flows are lumpy: an annual insurance premium, a large customer paying late, a piece of equipment bought once every five years. Accrual accounting spreads those flows into the periods they economically belong to, so that one quarter's profit can be compared with the next and with a competitor's.

The cost of that comparability is judgment. Deciding when a performance obligation is satisfied, how long equipment will last, or how much of a receivable will never be collected all require estimates. That is why accrual profit must always be read alongside the cash flow statement.

Revenue recognition: when revenue is earned

Revenue recognition answers one question: in which period does revenue belong? Under US GAAP the governing standard is ASC 606, and under IFRS it is IFRS 15. The two were developed jointly and are substantially the same. Both use a five-step model that applies to every contract with a customer.

The fifth step carries most of the timing consequence. Some performance obligations are satisfied at a point in time, typically when control of a product passes to the customer, such as on delivery. Others are satisfied over time, such as a twelve-month software subscription, a maintenance contract or a construction project, and the revenue is recognized progressively as the service is delivered.

Note what is absent from the model: cash. A customer can pay a year in advance or ninety days after delivery, and the revenue is recognized in the same periods either way. Payment terms change the balance sheet (receivables or deferred revenue), not the income statement.

Expense recognition and the matching principle

The matching principle says that expenses should be recognized in the same period as the revenues they help generate. The cost of the goods a retailer sells in March is expensed in March, when the sale is recorded, not in January when the inventory was bought. A sales commission earned on a March sale is expensed in March even if it is paid in April.

Not every cost can be traced to specific revenue. Rent, administrative salaries and insurance benefit the business over time rather than any single sale. These period costs are expensed in the period the resource is consumed. Long-lived assets such as machinery are capitalized on the balance sheet and expensed gradually through depreciation, a systematic allocation of cost over the periods that benefit from the asset.

Modern standard setters treat matching as a result of correctly applying the definitions of assets and liabilities rather than as a rule in its own right. A cost can be deferred on the balance sheet only if it creates something that meets the definition of an asset. Matching explains the goal, but it does not give a company license to push costs into future periods simply to smooth earnings.

The four adjusting entries: accruals and deferrals

At the end of each period, accountants make adjusting entries so the income statement reflects what was earned and incurred. Every one of them falls into one of four types, defined by two questions: is it revenue or an expense, and did the cash move before or after the economic event?

Accruals are recorded when the economic event happens before the cash. Accrued revenue, also called unbilled revenue or a contract asset, is revenue earned for work done that has not yet been invoiced or paid. Accrued expenses, also called accrued liabilities, are costs incurred but not yet paid, such as wages earned by employees since the last payday, interest accumulated on a loan, or a utility bill for December that arrives in January.

Deferrals are recorded when the cash moves before the economic event. Deferred revenue, also called unearned revenue or a contract liability, is cash received before the goods or services are delivered. Prepaid expenses are cash paid before the resource is consumed, such as insurance or rent paid in advance.

Each adjustment creates a balance sheet account that unwinds in a later period. That unwinding is why the working capital lines on the cash flow statement exist: they reverse the timing differences to get from accrual profit back to cash.

One business under both bases

Alder Consulting is a hypothetical advisory firm that starts Year 1 with $50,000 of cash contributed by its owners and nothing else. Its activity for the year is summarized below. Taxes are ignored to keep the focus on timing.

Alder delivers and bills $500,000 of work, of which customers pay $440,000 by year end. In December a new client pays a $30,000 retainer for work that will be done in January. Staff earn $280,000 of salaries, of which $265,000 has been paid (the last three days of payroll are accrued). Alder pays $60,000 of rent: $48,000 covering Year 1 and $12,000 in advance for January to March of Year 2. It buys $36,000 of computer equipment on January 1 with a three-year life and no residual value. Utilities cost $20,000 for the year, and the December bill of $4,000 is unpaid at year end.

Reconciling the two profit figures

The $47,000 gap between accrual and cash profit is not an error. It is fully explained by the balance sheet accounts that accrual accounting creates, and the reconciliation below is exactly the logic of the indirect method cash flow statement. Each asset created by accrual accounting (a receivable, a prepaid, capitalized equipment) means profit was recognized or cost was deferred without the matching cash, so it is subtracted. Each liability created (deferred revenue, accrued wages, accrued utilities) means cash was received or kept, so it is added.

The accrual balance sheet at year end also balances, which confirms the entries are complete. Alder's assets are cash of $143,000 (the opening $50,000 plus the $93,000 of cash profit), receivables of $60,000, prepaid rent of $12,000 and equipment of $24,000 net of depreciation, for a total of $239,000. Its liabilities are deferred revenue of $30,000, accrued salaries of $15,000 and accrued utilities of $4,000, a total of $49,000. Equity is the $50,000 contributed plus $140,000 of retained profit, $190,000. Liabilities plus equity equal $239,000.

Where accruals go wrong

Because accruals rest on estimates and timing judgments, they are where reported earnings are most easily shaped, sometimes innocently and sometimes not. Recognizing revenue before the performance obligation is satisfied, such as shipping goods customers did not order in the last week of a quarter, pulls future profit into the present. Under-accruing expenses, such as leaving a bonus or a warranty cost unrecorded, flatters margins until the bill arrives. Capitalizing costs that should be expensed moves operating cost onto the balance sheet.

The common signature of all three is profit that grows faster than operating cash flow over several periods, with receivables, inventory or capitalized costs growing faster than revenue. A single period of divergence can be ordinary timing. A persistent one deserves a question.

The opposite also matters for valuation. A business that bills annually in advance, like Northgate, carries large deferred revenue and generates cash ahead of its profit. A buyer that values it on EBITDA alone and ignores the working capital unwind can overpay if the billing terms change after closing.