Most businesses need immediate feedback about how well they are doing. For example, management usually wants monthly reports on financial results, most large corporations are required to present quarterly and annual financial statements to stockholders, and the Internal Revenue Service requires all businesses to file annual tax returns. Many business transactions affect more than one of these arbitrary time periods. For example, a new building purchased by Bank of America or a new airplane purchased by Southwest Airlines will be used for many years. It does not make sense to expense the full cost of the building or the airplane at the time of purchase because each will be used for many subsequent periods. Instead, we determine the impact of each transaction on specific accounting periods. When determining the amount of revenues and expenses to report in a given accounting period can be challenging. Proper reporting requires an understanding of the nature of the company’s business. Two principles are used as guidelines; they are the revenue recognition principle and the matching principle.
The revenue recognition principle requires that companies recognize revenue in the accounting period in which it is earned. For example, in a service company, revenue is considered to be earned at the time the service is performed. When recognizing expenses, a simple rule is followed; “Let the expenses follow the revenues.” Which means expense recognition is tied to revenue recognition.
The practice of expense recognition is referred to as the matching principle because it dictates that efforts (expenses) be matched with accomplishments (revenues). Recognizing expenses too early overstates current period expense; recognizing them too late understates current period expense.
Cash-basis and accrual-basis accounting use different criteria for determining when to recognize and record