When revenues and corresponding expenses are reported in the period they belong to. When the expense cannot be matched to a sales period the expense will be recognized in the period it will be used in. To determine a company’s profitability for a period it is necessary to report expenses in the period the associated revenue is reported.
For some revenues and expenses matching is a very simple process. You sell a product you recognize the revenue, you take the product out of inventory, the product cost is recognized, and your revenue less your expense for this product is your profit. Not all expenses are this cut and dry.
Cost of goods sold is generally easier to match in a sales period. Normal inventory systems will help you account for your sales and your outgoing inventory but there are other expenses that require more thought. Annual insurance is one.
Annual insurance may be paid in one lump sum or may be paid on a monthly basis. The cash going out each month can be set up to recognize the monthly expense. However in some cases there are not 12 equal payments to process as some insurance companies require a down payment and then 6-8 monthly payments. Processing a down payment as a monthly expense does not follow the matching principle rule as this expense will be more than 1/12 of the annual expense.
Larger companies will have a prepaid expense account set up where they will debit the prepaid asset account with the prepayment amount and each month they will credit the account by the 1/12 expense and debit the insurance expense account recognizing the proper amount of insurance expense for the period.
Another matching principle concern with insurance is an overlap for the fiscal year. Smaller companies that may pay the full amount of the insurance up front generally expense the entire insurance amount at the time they pay it. This does not follow the matching principle however the year-end accountants will adjust the entry and expense the proper amount of insurance in the fiscal year and create a prepaid account where they will account for the portion that does not belong in the expense for the fiscal year.
Paying the insurance upfront will affect your cash flow as the cash outflow happens at the time you pay the expense. In accounting when you pay for something and when you can recognize the expense are two different things. It is important to recognize your costs for the period they belong to so you can see the true profitability of your business.