Abstract:
The matching principle is a culmination of accrual accounting and the revenue recognition principle. They both determine the accounting period in which the revenues and expenses are recognized as for the revenue recognition is the same as the matching principle the difference between them is only that for the matching principle the expenses are recognized when the obligation is incurred as for the revenue principle the revenue are recognized when they are earned for example when the goods are transferred
Introduction:
The process of calculating accounting profit for a year by matching the revenue earned in a period against the expenses incurred in a period is known as accrual accounting or the matching concept. Accrual accounting matches revenues with expenses for a particular period and this is the basis of the matching principle. Accrual accounting demands that expenses be matched with the revenue that was generated from those expenses.
Discussion ( Content of the report):
Typically, businesses with revenue of more than a few million dollars opt for accrual accounting to handle the greater financial complexity their companies face. Choosing the right accounting method can make the difference between an accurate reading of profit and loss and a conceptual figure which is clueless. A manager who does not know how to look at the numbers from both accounting points of view may not be able to identify when his business is in trouble.
Cash accounting will show that there is really no money in the bank or if the current favourable revenue picture will be offset next month by heavy expenses. Accrual accounting, on the other hand, matches revenue and expenses within a given financial period to avoid surprises. To understand the differences between the two accounting methods, a numerical example is shown. Suppose a firm is running an e-commerce Website. A customer orders $100 worth of merchandise in June and pays immediately with a credit card. However, in July, the customer backs out of the sale by cancelling the credit-card transaction but keeps the merchandise which has already been shipped. The firm is now stuck with a debt that may take months to resolve through collection agencies.
Under cash accounting, that $100 in income recorded in June is recorded as a negative $100 income in July which shows your financial standing immediately. But under accrual accounting, that $100 is recorded in income in June. When the transaction is cancelled, receivables (cash) owed to the company increase by $100 in July to compensate for the lack of payment. About a year later, if the debt is impossible to collect, the bad debt is recorded as a $100 expense and decrease receivables by $100. The accrual method takes into consideration when transactions actually occur (Steve, 1999: 52).
When comparing the financial performance of UK and US law firms, it is crucial to understand that one is not necessarily comparing like with like since US firms account on a cash basis and UK firms on an accrual basis. This implies that the US firm only treats the value of work billed and paid for as income. In the UK, however, firms treat the value of work billed and the value of work done but not yet billed as income. The UK firm may adjust the value of billed work to make general provisions for bad debts. Near the financial year end, US firms will be more focused on getting bills paid, especially if their firm adopts a merit-based renumeration system. For a UK firm, however, the focus near the year end is more on billing rather than collecting payments (Williams, 2003:28).
Recently, The International Federation of Accountants (IFAC) has called on the G20 Governments to practise greater transparency in their accounting systems to restore confidence in sovereign debt. The CEO of the IFAC said despite the clear advantages of accrual-based accouting and the fact that it is required by Governments for public companies, many of them continue to use cash-accounting. The IFAC is encouraging Governments to adopt an accrual-based measure of surplus or deficit (Sweet, 2010).
A survey conducted of 237 local governments in the Italian public sector reveals their perceptions towards the introduction of accrual accounting to supplement the traditional cash-based accounting system. Many countries worldwide have been experimenting with accruals accounting for all or some of their Governments. For example New Zealand, Australia, the United Kingdom, Spain, Sweden, Canada, France, Belgium, Ireland, Finland and the European Union. The International Federation of Accountants still permits other accounting systems, but openly supports the superiority of accruals accounting, which it claims can better show: (1) compliance with legal and contractual requirements; (2) sources, allocation and uses of financial resources; (3) financing and cash requirements; (4) ability to finance activities and to meet liabilities and commitments. Nevertheless, an increasing amount of literature, at international level, has criticised the adoption of accruals accounting by public organisations. According to them accruals accounting would not be suited to the public sector because: (1) profit is not a goal and therefore cannot be a relevant measure of performance; (2) financial structure and solvency are not relevant in the public sector; (3) accruals accounting does not measure outcomes; (4) accruals accounting provides a narrow idea of performance, focusing on cost of services and efficiency. (Nasi and Steccolini, 2008: 175).
New Zealand's public sector which used the cash-based accounting system published its first set of accruals-based financial statements in April 1992 (Lye, Perera and Rahman, 2005: 784).
Originally, accrual accounting was developed for private firms, which are income-generating entities. A comparison of revenues and cost yields a profit or a loss. In a commercial environment this is a measure to interprete efficiency. The Government, however, is normally an income-spending household. It raises tax revenues that are spent on public outlays. It is not so much the financial result that is useful, but rather the social outcome of the public expenditures. (Hoek, 2005: 32)
ABC is an advertising company. If it used the accrual method, it would record the full amount of the sale of advertising designs. But if it used the cash method, it would record only the money it has been paid so far. An example comparing its profit and loss statement prepared using the accrual concept in column B compared to cash accounting in column C is shown below. The resulting profit and loss account using the two methods are then compared (Steve, 1999: 52).
ABC COMPANY
PROFIT AND LOSS STATEMENT (Steve, 1999: 52).
B - Accrual Method
C - Cash Method
A
B
C
Income:
Ad Designs
$23,895.00
$11,017.00
Marketing Research
$82,016.07
$53,336.52
Online Marketing Income
$ 6,859.00
$3,300.00
Packaging Design
$35,662.89
$21,551.34
Web Site Designs
$50,535.18
$40,035.18
(2)Total Income
$198,968.14
$129,240.04
Expenses:
Advertising
$5,066.78
$4,434.78
Automobile Expense
$5,243.54
$3,830.14
Bank Service Charges
$ 266.31
$266.31
Independent Contractors
$9,679.05
$8,557.03
Office Expenses/Supplies
$16,451.55
$14,633.49
Payroll Expenses
$63,775.62
$63,775.62
Printing and Reproduction
$3,792.32
$3,792.62
Rent
$18,100.00
$16,200.00
Software Programs
$ 744.00
$0.00
Telephone/Utilities
$17,301.45
$13,929.12
Travel & Entertainment
$1,131.02
$3,667.72
Total Expenses
$141,551.64
$133,086.53
Net Income
$57,416.50
(-$3,846.49) (4)
Customers paid most of their bills, but not quite all. Therefore, cash accounting lags slightly behind here.
Tool income for the two methods is different because accrual accounting shows everything that has been paid to ABC plus everything that is owed, while the cash method shows only what ABC has been paid.
Not all of ABC's debt has already been paid. Under the accrual method, the books showed the full amount owed by ABC at the moment the services were offered. Thus, the accrual method shows the total amount paid plus the amount still owed. The cash method, on the other hand shows only what has been paid by ABC.
The bottom line is the most different figure for the two accounting methods. Since other firms paid ABC less than it was owed, the cash accounting method shows the company lost money. The cash method correctly indicates that ABC probably should not write any big cheques until more of its customers pay. Accrual accounting, however, shows that ABC is comfortably in the black for the year by matching up actual revenue and expenses (Steve, 1999: 52).
Conclusion:
The accrual or the matching concepts is makes sure that the revenue or the expenditures must be matched to that period in which they are realized or in other words the cash is received or paid. Its is called the matching concept because the revenue which is earned have to be offset against the expenses incurred in earning it.
( 1318 words)
