Revenues and Matching Expenses
According to the principle of revenue recognition, revenues are recognized in the period when it is earned (buyer and seller have entered into an agreement to transfer assets) and realized or realizable (cash payment has been received or collection of payment is reasonably assured).
For example, if a company enters into a new trading relationship with a buyer, and it enters into an agreement to sell the buyer some of its goods. The company delivers the products but does not receive payment until 30 days after the delivery. While the company had an agreement with the buyer and followed through on its end of the contract, since there was no pre-existing relationship with the buyer prior to the sale, a conservative accountant might not recognize the revenue from that sale until the company receives payment 30 days later.
Expense Recognition
The assets produced and sold or services rendered to generate revenue also generate related expenses. Accounting standards require that companies using the accrual basis of accounting and match all expenses with their related revenues for the period, so that the income statement shows the revenues earned and expenses incurred in the correct accounting period.
A Sample Income Statement
Expenses are listed on a company's income statement.
The matching principle, part of the accrual accounting method, requires that expenses be recognized when obligations are (1) incurred (usually when goods are transferred, such as when they are sold or services rendered) and (2) the revenues that were generated from those expenses (based on cause and effect) are recognized.
For example, a company makes toy soldiers and acquires wood to make its goods. It acquires the wood on January 1st and pays for it on January 15th. The wood is used to make 100 toy soldiers, all of which are sold on February 15. While the costs associated with the wood were incurred and paid for during January, the expense would not be recognized until February 15th when the soldiers that the wood was used for were sold.
If no cause-and-effect relationship exists (e.g., a sale is impossible), costs are recognized as expenses in the accounting period they expired (e.g., when they have been used up or consumed, spoiled, dated, related to the production of substandard goods, or the services are not in demand). Examples of costs that are expensed immediately or when used up include administrative costs, R&D, and prepaid service contracts over multiple accounting periods.
The Effect of Timing on Revenues & Expenses
Often, a business will spend cash on producing their goods before it is sold or will receive cash for good sit has not yet delivered. Without the matching principle and the recognition rules, a business would be forced to record revenues and expenses when it received or paid cash. This could distort a business's income statement and make it look like they were doing much better or much worse than is actually the case. By tying revenues and expenses to the completion of sales and other money generating tasks, the income statement will better reflect what happened in terms of what revenue and expense generating activities during the accounting period.