In accrual accounting, the matching principle
states that expenses should be recorded during the period in which they
are incurred, regardless of when the transfer of cash occurs.
Conversely, cash basis accounting calls for the recognition of an expense when the cash is paid, regardless of when the expense was actually incurred.
If no cause-and-effect relationship exists (e.g., a sale is impossible), costs are recognized as expenses in the accounting period 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 assets
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 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.
The matching principle allows for a more objective analysis of
profitability. 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.
