Source: Chapter 3, Introduction to Management Accounting (University of Minnesota Twin Cities)
Difficulty: Introductory | Prerequisites: Part 1 of this chapter (income statement structure, operating vs non-operating items) and the debit/credit framework from Chapters 1–2.
This is the conceptual heart of Chapter 3. Once you know what an income statement looks like (Part 1), the next question is: when do revenues and expenses actually get recorded? The answer, under GAAP, is accrual accounting, which records economic events when they happen rather than when cash changes hands. This section covers the revenue recognition principle, the matching principle, and how to analyse common transactions (prepaid expenses, unearned revenue, cost of goods sold) using the accrual framework. If you are behind, make sure you are comfortable with the distinction between operating and non-operating items before diving in.
Cash basis accounting records revenue when cash arrives and expenses when cash leaves, but this can be misleading. Accrual accounting, required by GAAP, records revenue when it is earned (goods or services delivered) and expenses when they are incurred (benefits used up), regardless of when cash moves. The matching principle ties expenses to the revenues they helped generate in the same period.
Cash basis accounting
A method that records revenue when cash is received and expenses when cash is paid out.
In simple terms, if cash comes in, it is revenue; if cash goes out, it is an expense. Simple, but it often paints an inaccurate picture of what really happened economically.
Accrual basis accounting
A method, required by GAAP, that records revenue when it is earned and expenses when they are incurred, regardless of when cash changes hands.
Think of it as recording economic reality rather than bank-account activity. You delivered the service in March, so March gets the revenue, even if the customer pays in April.
Revenue recognition principle
The rule specifying the timing and amount of revenue to be recognised during an accounting period. Revenue is recorded when goods or services are delivered to the customer.
The trigger is delivery, not payment. Cash can arrive before, at the same time as, or after delivery.
Matching principle (expense recognition)
The principle that expenses should be recorded in the same period as the revenues they helped generate.
If you sold widgets in June, the cost of making those widgets belongs in June's income statement, even if you paid for the raw materials in April.
Recognition issue
The question of when the effects of operating activities should be recorded in the accounts.
Measurement issue
The question of what dollar amounts should be recognised for those activities.
Time period assumption
The assumption that business activities can be divided into discrete time periods (months, quarters, years) for reporting purposes.
Without this assumption, you would have to wait until a business closed its doors to know whether it was profitable.
Prepaid expenses (prepaid "stuff")
Payments made in advance for goods or services that will be consumed in future periods. Examples: prepaid rent, prepaid insurance, prepaid advertising.
The cash goes out now, but the expense is recognised later, as the benefit is used up period by period. Until then, the prepaid amount sits on the balance sheet as an asset.
Unearned revenue (deferred revenue)
Cash received from a customer before the company has delivered the goods or services.
This is a liability, not revenue. The company owes the customer a future delivery. Revenue is recognised only when the goods or services are provided.
Cost of goods sold (COGS)
The expense recognised when inventory is sold to a customer, recorded at the inventory's original cost.
When a product leaves the shelf and goes to a buyer, its cost moves from the inventory asset account to COGS on the income statement.
Expenditure
Any outflow of cash, for any purpose: paying an expense, buying an asset, repaying a debt.
Think of it as the broad category. Every expense involves an expenditure (eventually), but not every expenditure is an expense. Buying a delivery van is an expenditure, not an expense.
Expense
The cost of goods or services that have been used up or consumed in the process of generating revenue.
The narrower category. The van becomes an expense gradually through depreciation, as its usefulness is consumed over time.
Under the cash basis, the rules are blunt:
Cash comes in = revenue
Cash goes out = expense
This is straightforward but misleading. A company could collect a large payment in December for work it will not perform until February, inflating December's income and deflating February's.
Accrual accounting solves this by tying recognition to economic events:
Revenue is recorded on the date goods or services are delivered to the customer.
Expenses are recorded when the related benefit is received or used up.
GAAP requires accrual accounting because it produces financial statements that more closely reflect economic reality.
The revenue recognition principle specifies when and how much revenue to record. The key trigger is delivery of goods or services, not the receipt of cash.
Cash can arrive at three different times relative to delivery:
Before delivery – the company receives cash but has not yet earned it (this creates unearned revenue, a liability)
At the time of delivery – cash and revenue recognition happen simultaneously
After delivery – the company has earned the revenue but cash has not arrived yet (this creates an accounts receivable, an asset)
In all three cases, revenue is recorded on the date of delivery.
Revenues are credits. When you record revenue, you credit a revenue account.
Expenses follow revenues. The matching principle says: record expenses in the same period as the revenues they helped produce.
If you sold products in July, the cost of those products (COGS) belongs in July.
If you used a month's worth of insurance coverage in July, that month's share of the insurance premium is a July expense, even if you paid the full annual premium in January.
The trigger for expense recognition is the consumption of the benefit, not the payment of cash.
Expenses are debits. When you record an expense, you debit an expense account.
Not every cash outflow is an expense. Cash expenditures break down into three buckets:
Expenses – benefits already used up (supplies consumed, rent for the current month)
Asset purchases – benefits to be used in the future (equipment, prepaid insurance)
Debt payments – repaying what was borrowed (loan principal)
Only the first category hits the income statement. The other two affect the balance sheet.
When a company pays for something in advance (rent, insurance, advertising), the payment is not an expense yet. It is an asset: the company now owns a future benefit.
As the benefit is consumed period by period, the asset shrinks and the expense is recognised. For example, paying 12 months of rent upfront creates a prepaid rent asset. Each month, one-twelfth moves from prepaid rent (balance sheet) to rent expense (income statement).
The mirror image of prepaid expenses, but from the seller's perspective. When a company receives cash before delivering goods or services:
It cannot record revenue, because nothing has been delivered.
It records a liability (unearned revenue), representing the obligation to deliver in the future.
When delivery occurs, the liability decreases and revenue is recognised (credited).
A magazine subscription paid upfront is a classic example. The publisher has the cash but owes twelve issues. Each month of delivery converts a portion of unearned revenue into earned revenue.
When a company sells goods from its inventory, the related expense is called cost of goods sold. Key rules:
COGS is always recorded at the inventory's original cost, not its selling price.
COGS is recorded at the same time as the sale (matching principle).
The journal entry debits COGS (expense up) and credits inventory (asset down).
Revenue recognition timing rule
Record revenue on the date goods or services are delivered, regardless of when cash is received.
Matching principle rule
Record expenses in the same period as the revenues they helped generate, regardless of when cash is paid.
COGS journal entry pattern
Debit: Cost of Goods Sold (expense increases) Credit: Inventory (asset decreases)
Prepaid expense pattern
At payment: Debit Prepaid Asset, Credit Cash As benefit is used: Debit Expense, Credit Prepaid Asset
Unearned revenue pattern
At cash receipt: Debit Cash, Credit Unearned Revenue (liability) At delivery: Debit Unearned Revenue, Credit Revenue
Every subscription business (streaming services, SaaS platforms, gym memberships) deals with unearned revenue daily: customers pay upfront, and the company recognises revenue month by month as it delivers the service. Prepaid expenses show up whenever a company pays rent or insurance in advance, which is standard practice. Understanding these mechanics is essential for anyone reading or preparing real financial statements.
Students often think revenue is recorded when cash is received. Under accrual accounting, revenue is recorded when goods or services are delivered. Cash timing is irrelevant to revenue recognition.
Students confuse "expenditure" with "expense." Buying a piece of equipment is an expenditure (cash goes out), but it is not an expense until the equipment's usefulness is consumed through depreciation.
A common mistake is recording unearned revenue as revenue immediately. If you have received cash but not delivered anything, you have a liability, not revenue.
Students sometimes apply the matching principle backwards, trying to match revenues to expenses rather than expenses to revenues. The logic runs: first identify the revenue earned in a period, then match the related costs to that same period.
⚠️ Expect scenario questions: "A company receives $6,000 cash on 1 March for six months of service. How much revenue is recognised in March?" You must apply revenue recognition (delivery), not cash basis thinking.
⚠️ Be able to write journal entries for prepaid expenses, unearned revenue, and cost of goods sold. Know which accounts are debited and credited at each stage.
⚠️ The distinction between expenditure and expense is a common multiple-choice trap. If cash goes out for something that will benefit future periods, it is an asset, not an expense.
⚠️ Know that revenues are credits and expenses are debits. This will appear in transaction analysis questions.
True or false: Under accrual accounting, revenue is recorded when cash is received. (False. Revenue is recorded when goods or services are delivered.)
Fill in the blank: The ________ principle says expenses should be recorded in the same period as the revenues they helped generate. (Matching)
True or false: Prepaid rent is an expense on the income statement at the time of payment. (False. It is an asset until the rental period is used up.)
Fill in the blank: Cash received before delivering goods or services is recorded as ________, a liability. (Unearned revenue)
True or false: COGS is recorded at the selling price of the inventory. (False. COGS is recorded at the original cost of the inventory.)
Q: On 1 December, a company receives $12,000 cash for a 12-month service contract. How much revenue does it recognise in December? What is the journal entry at 1 December?
A: Revenue recognised in December: $1,000 (one month of service delivered). At 1 December, the entry is: Debit Cash $12,000, Credit Unearned Revenue $12,000. At 31 December, an adjusting entry recognises one month: Debit Unearned Revenue $1,000, Credit Service Revenue $1,000.
Q: A company pays $2,400 for a two-year insurance policy on 1 January. What is the expense recognised in the first month?
A: $100. The monthly expense is $2,400 / 24 months = $100. At payment, the full amount is a prepaid asset. Each month, $100 moves from prepaid insurance to insurance expense.
Q: Explain the difference between an expenditure and an expense, using the purchase of office equipment as an example.
A: The cash paid for the equipment is the expenditure. The equipment is an asset because its benefit extends over multiple periods. The expense is recognised gradually through depreciation as the equipment is used up. The expenditure happens once; the expense is spread across the asset's useful life.
Q: A retailer sells a product for $80 that it originally purchased for $50. What journal entries are recorded at the time of sale?
A: Two entries: (1) Debit Cash (or Accounts Receivable) $80, Credit Sales Revenue $80. (2) Debit Cost of Goods Sold $50, Credit Inventory $50. The revenue is recorded at the selling price; COGS is recorded at the original cost.
Q: Under cash basis accounting, a company that receives $10,000 in December for work to be done in February would report $10,000 of revenue in December. How does accrual accounting treat this differently, and why?
A: Under accrual accounting, no revenue is recorded in December because no service has been delivered. The $10,000 is recorded as unearned revenue (a liability). Revenue is recognised in February when the work is performed. This gives a more accurate picture of each period's economic activity.
Accrual accounting is the foundation for adjusting entries (typically covered in Chapter 4), where prepaid expenses, unearned revenues, accrued expenses, and accrued revenues are updated at the end of each period. The matching principle also underpins depreciation, which you will encounter when studying long-term assets. Understanding the difference between cash flows and accrual-based income is central to the statement of cash flows, usually covered later in the course.
Accrual accounting, cash basis accounting, accrual vs cash, revenue recognition principle, matching principle, expense recognition, time period assumption, recognition issue, measurement issue, prepaid expenses, prepaid rent, prepaid insurance, deferred revenue, unearned revenue, cost of goods sold, COGS, expenditure vs expense, GAAP, journal entries for revenue, journal entries for expenses, debit and credit rules, ACCT 100, introduction to management accounting, University of Minnesota