In our day-to-day lives, most of us use "cash accounting." That is, we pay the cell phone or cable bill and immediately deduct that amount from our checking account and, if we use a program like Quicken, enter that as a household utility expense or some such. If we happen to pay it on the seventh of the month, it goes into that month's expenses, even though the bill was for the cable television we watched in the previous month.
Companies don't keep track of things that way. They have to make it more complicated by using "accrual accounting."
What they do is match the time frame of the revenue they bring in with the time frame of the expenses made to get that revenue. For instance, suppose the company sells 10,000 widgets at $5 each in April. Their revenue would be $50,000. Now suppose they bought all of the 10,000 widgets on the first of April (our favorite day of the year) at $2 each, but they didn't pay the bill until the first of May. In May, they don't sell anything and don't buy anything.
Under cash accounting:
- April revenue = $50,000 and April expense = $0
- May revenue = $0 and May expense = $20,000
Note the displacement in time of the revenue and the expense. This is just like you paying in May for the TV you watched in April.
Under accrual accounting and the matching principle, it would be:
- April revenue = $50,000 and April expense = $20,000
- May revenue = $0 and May expense = $0
Note now that the expense used to generate the revenue (the purchase of the widgets) is matched up with that revenue (from the sale of the widgets). This is how the expense would be recorded, even though the cash to pay for the widgets didn't leave the company until May first.
The matching principle and accrual accounting leads to all sorts of things like the above. Balance sheet items such as Accounts Receivable, Accounts Payable, Wages Payable, and Prepaid Insurance all come about because the timing of paying or receiving cash does not exactly correspond with the matched timing of the revenue and its related expenses. Depreciation is another example of the difference in timing between paying cash and recording an expense.