1. What an accrual is and how it relates to the matching principle
Let’s start with a quick example. A company pays its hourly employees every two weeks on the day following the pay period. The very last payroll disbursement for a given year takes place four days before the end of the fiscal year. The next payroll disbursement will take place ten days after the new fiscal year begins. Does the company have to worry about the payroll expense for the four days in the current fiscal year? If so, what does the company have to do to account for the services employees provided before the end of the year, but which will not be paid for until the next year?
Before we proceed to answer these questions, let’s look at several concepts that will be helpful in analyzing the answers. The first one is the matching principle .
Matching principle says that expenses incurred in generating revenues should be recognized in the period in which those revenues are recorded.
For instance, a company hires an employee who provides services to the company’s clients. Revenues from the services provided are recorded in the current year. According to the matching principle, the payroll expense for the employee should be recognized in the same year even if the payroll check is not cut until the following year. Consequences of not following the matching principle include understated
expenses and overstated net earnings. The matching principle helps owners and inventors to see the actual earnings the company generated during the year because all revenues and expenses are matched.
Another concept that we will take a look at is accruals. Accruals are closely related to the matching principle and represent an integral part of accrual (accrual basis) accounting. Most large companies apply accrual accounting (versus cash accounting utilized by small companies), so the concept of accruals is very familiar to them.
Accrual refers to the recognition of expenses before cash flow related to the accrued item takes place.
The process of accruing for expenses may not be an issue or required in the middle of a fiscal period. However, when the fiscal period end comes, accruals help make sure the matching principle is observed. For example, when a company pays for salaries and wages (i.e. payroll expenses) during a fiscal period, the company records the payroll expense at the time of cutting payroll checks or making payroll direct deposits. However, sometimes a pay period is split by the end of a fiscal period. This means that employees provide services to the company for a period of time before the end of the fiscal period, but will not get paid until after the end of it. How would the company ensure that the matching principle is observed in this case? The answer is to use accruals.