Accounting: The Language of Business (Part 12)

“There are only two things as complicated as insurance accounting and I have no idea what they are.” —Andrew Tobias

The Matching Concept and the Adjusting Process (Part A)

by

Charles Lamson

Assume that you rented an apartment last month and signed a nine-month lease. When you signed the lease agreement, you were required to pay the final months rent of $500. This amount is not refundable to you.

You are now applying for a loan at a local bank. The loan application requires a listing of all your assets. Should you list the $500 deposit as an asset?

The answer to this question is "yes." The deposit is an asset to you until you receive the use of the apartment in the ninth month.

A business faces similar accounting problems at the end of a period. A business must determine what assets, liabilities, and owner's equity should be reported on its balance sheet. It must also determine what revenues and expenses should be reported on its income statement.

As was illustrated in previous posts, transactions are normally recorded as they take place. Periodically, financial statements are prepared, summarizing the effects of the transactions on the financial position and operations of the business.

At any one point in time, however, the accounting records may not reflect all transactions. For example, most businesses do not record the daily use of supplies. Likewise, revenue may have been earned from providing services to customers, yet the customers have not been billed by the time the accounting period ends. Thus, at the end of the period, the revenue and receivable accounts must be updated.

In the next few posts, we describe and illustrate this updating process. We will focus on accounts that normally require updating and the journal entries that update them.

The Matching Concept

When accountants prepare financial statements, they assume that the economic life of the business can be divided into time periods. Using this accounting period concept, accountants must determine in which period the revenues and expenses of the business should be reported. To determine the appropriate period, accountants will use either (1) the cash basis of accounting or (2) the accrual basis of accounting.

Under the cash basis, revenues and expenses are reported in the income statement in the period in which cash is received or paid. For example, fees are recorded when cash is received from clients, and wages are recorded when cash is paid to employees. The net income (or net loss) is the difference between the cash receipts (revenues) and the cash payments (expenses).

Under the accrual basis revenues are reported in the income statement in the period in which they are earned. For example, revenue is reported when the services are provided to customers. Cash may or may not be received from customers during this period. The concept that supports this reporting of revenues is called the revenue recognition concept.

Under the accrual basis, expenses are reported in the same period as the revenues to which they relate. For example, employee wages are reported as an expense in the period in which the employees provided services to customers, and not necessarily when the wages are paid.

The accounting concept that supports reporting revenues and related expenses in the same period is called the matching concept, or matching principle, under this concept, an income statement will report the resulting income or loss for the period.

Generally accepted accounting principles require the use of the accrual basis. However, small service businesses may use the cash basis because they have few receivables and payables. For example, attorneys, physicians, and real estate agents often use the cash basis. For them, the cash basis will use financial statements similar to those prepared under the accrual basis.

For most large businesses the cash basis will not provide accurate financial statements for user needs. For this reason, we will emphasize the accrual basis in this analysis. The accrual basis and its related matching concept require an analysis and updating of some accounts when financial statements are prepared. In the next post we will describe and illustrate this process called the adjusting process.

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 102-103*

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