Accrual basis and matching principle are two helpful accounting principles, but they often become entry points for companies to manipulate their profits.
So, why does that happen?
Before delving into that, let's make sure we're on the same page about what accrual basis and matching principle actually mean. Okay, here's the breakdown.
Table of Contents
- Decoding Accrual and Matching Principles
- Uncollectible Receivables: Matching Principles
- Warranty Expense Management: The Matching Approach
- Channel Stuffing: Exploiting Accrual Principles for Fraud
- Accounting Fraud: Exploiting Accrual and Matching Principles
- Expense Capitalization: Exploring Accrual and Matching Principles
- Unveiling Accounting Fraud: Accrual and Matching Principles
Decoding Accrual and Matching Principles
Accrual basis is a recording system where a company can recognize revenue when the product is delivered to the customer or the service is completed, regardless of whether cash has been received or not.
In accrual basis, we also need to recognize expenses that have already been incurred even if we haven't paid them or no cash has been disbursed yet.
When it comes to expenses, it's not just about stopping there; based on the matching principle, we also need to recognize expenses directly related to revenue in the same period.
Still confused?
Here's the deal: let's say a company produces and sells 100,000 tires in 2024; then, the production costs of those 100,000 tires sold must also be recognized in 2024.
This includes raw material costs, labor wages, factory overhead costs, and even the costs of uncollectible receivables and warranty expenses for the tires sold. All need to be recognized in 2024.
Wait, hold up! Production costs need to be recognized in the same period as the sales. That's understandable!
But why do we need to recognize uncollectible receivables in 2024 too??? How do we know if the customers won't pay in the future?
And warranty expenses, if the claims happen in 2025, how do we know?? Do we need a time machine to see the claims??
LOL, no need for a time machine. Let me explain one by one!
Uncollectible Receivables: Matching Principles
Regarding uncollectible receivables, we simply need to establish a provision for doubtful accounts in 2024. To estimate its value, we can examine historical uncollectible accounts or create an aging schedule for accounts receivable, where the longer the receivable, the higher the provision for doubtful accounts.
Now, about warranty expenses. We just need to make provisions based on the company's historical claim experience over the past few years.
Oh okay, got it. So, how do we recognize them?
First, for uncollectible receivables. Once we have the estimated amount to be provisioned, we simply journalize that figure in 2024 by debiting bad debt expense and crediting the allowance for doubtful accounts.
See! Bad debt expense is recognized in the 2024 income statement or the same period as the sales, and the allowance for doubtful accounts is presented on the balance sheet as a reduction of the company's accounts receivable or as a contra account to accounts receivable.
Later on, if in 2025 it turns out that the customer doesn't pay the company's receivables, there's no need to recognize the bad debt expense from the 2024 sales in 2025, just debit the allowance for doubtful accounts and credit accounts receivable.
| Action | Debit | Credit |
|---|---|---|
| In 2024: | Bad Debt Expense | Allowance for Doubtful Accounts |
| In 2025 (if necessary): | Allowance for Doubtful Accounts | Accounts Receivable |
Wow, that's how it works! Pretty neat! So, what about recognizing warranty expenses?
Warranty Expense Management: The Matching Approach
Warranty expenses work similarly.
Once the company has the warranty expense figure in 2024, it just needs to debit warranty expense and credit warranty liability.
Debiting warranty expense ensures that product warranty expenses are recognized in the same period as the sales.
Then, if in the future, say in 2025, there's a warranty claim for sales made in 2024, the company just debits warranty liability and credits cash (if it's a money-back warranty) or credits inventory (if it's a tire replacement).
| Action | Debit | Credit |
|---|---|---|
| In 2024: | Warranty Expense | Warranty Liability |
| In 2025 (if necessary): | Warranty Liability | Cash or Inventory |
So, that's the accrual basis and matching principle!
Oh okay, got it. This really ensures that the company's net income for a period is accurately measured, right?
In theory, yes, but in reality, these accrual and matching principles are often misused to beautify financial statements.
Wait, how's that possible?
Oh, it happens! You see, simple things like recognizing bad debt expenses and warranty expenses are quite flexible in determining their values.
Channel Stuffing: Exploiting Accrual Principles for Fraud
So, picture this: if a company wants to boost its profits, it can just make moderate estimates or even optimistic estimates, making the bad debt expenses and warranty expenses smaller than they should be.
Got it!
Now, let's talk about the accrual principle. One famous misuse of this principle is called channel stuffing.
According to Investopedia, channel stuffing is when a company ships more goods to distributors and retailers than they actually need, often by offering incentives like big discounts or extended payment terms. [1]
What's the point of that?
Well, with the accrual basis, when the goods are shipped to the customers, the company can recognize the revenue in that period even if the payment hasn't been received yet.
So, it's all good according to accounting principles!
The problem is, it can mislead investors about the company's performance. All those extra goods mean potential returns in the future are huge.
And what happens next? Well, in future periods, the company needs to adjust its retained earnings. But in the current period, the company's profits have already been inflated because of this channel stuffing technique.
Some well-known companies that did this, as reported by Mololamken, are energy giant Enron, software company Autonomy, and pharmaceutical company Bristol Myers Squibb. [2]
| Concept | Description |
|---|---|
| Channel stuffing: | Shipping excess goods with incentives to distributors. |
| Accrual principle: | Recognize revenue on shipped goods, not yet paid for. |
| Impact: | Boosts current profits, misleads investors. |
| Adjustment: | Future periods adjust earnings for potential returns. |
| Examples: | Enron, Autonomy, Bristol Myers Squibb. |
| Conclusion: | Channel stuffing misuses accrual principles, equals fraud. |
So, grasp the idea that misusing accrual principles, such as channel stuffing, equals accounting fraud!
Accounting Fraud: Exploiting Accrual and Matching Principles
Accounting fraud stands apart from other corporate crimes like embezzlement, insider trading, or money laundering.
As quoted by AccountingTools, accounting fraud involves the intentional manipulation of financial statements or tax returns for personal or corporate gain. For instance, a business might overstate its revenue, understate its expenses, overstate its assets, or understate its liabilities. [3]
So, accounting fraud can take various forms, and channel stuffing is just one of its many techniques.
But how does accounting fraud happen? Well, it's often due to the creativity of accountants in exploiting the gaps in accrual and matching principles.
However, despite the fact that the accrual and matching principles can manipulate profits, they can't impact the cash report.
So, at this point, cash becomes more crucial than profit.
Expense Capitalization: Exploring Accrual and Matching Principles
When it comes to the matching principle, there are certain costs that can't be directly matched against sales in a single period. These include expenses related to acquiring fixed assets like machinery, buildings, and factories.
The costs associated with acquiring fixed assets are often substantial, and their utility extends over several years, ranging from 4 to 20. As a result, it's impractical to recognize them all in just one period.
In the case of fixed assets, the costs of acquisition aren't immediately recognized upon purchase. Instead, they are spread out over time through a process known as depreciation. Depreciation allocates the cost of fixed assets to each accounting period over their useful life.
Since acquisition costs aren't recognized immediately in the income statement, all fixed asset acquisition costs are recorded upfront on the balance sheet. This process is called capitalization.
According to Chron, capitalization involves recording a purchase as an asset rather than an expense for the period, followed by depreciating part of the purchase price over the asset's life. [4]
However, accounting imposes strict rules regarding expense capitalization, and not all costs can be capitalized.
This is where creative accountants come into play. One notable instance of exploiting expense capitalization occurred at WorldCom.
As reported by Floqast, WorldCom paid "line costs" to utilize third-party telecommunications networks and lines. [5]
Ordinarily, these costs are treated as expenses in Generally Accepted Accounting Principles (GAAP). However, WorldCom capitalized approximately $3 billion of these line costs between 2001 and 2002, boosting their profits by the same amount.
| Concept | Description |
|---|---|
| Matching principle: | Fixed asset costs spread over useful life, not directly matched against sales. |
| Depreciation: | Allocate fixed asset costs to each accounting period. |
| Capitalization: | Record fixed asset acquisition costs on balance sheet upfront. |
| Expense capitalization: | Strict rules on which costs can be capitalized. |
| Example: | WorldCom capitalized line costs, inflating profits by $3 billion. |
| Impact: | Recording costs as assets misleads stakeholders, inflates profits. |
This means they recorded these costs as assets rather than direct expenses, thereby making their profits appear larger.
Unveiling Accounting Fraud: Accrual and Matching Principles
Tapping into the gaps created by the accrual and matching principles might seem like a piece of cake at first glance. But trust me, the repercussions are no joke.
Just picture how many investors were taken in by the company's performance, pouring money into those firms. But in the end, those investors are sure to lose out because they invested in companies that didn't perform as well as they claimed.
And the consequences for accounting crimes aren't a walk in the park either. Executives face hefty fines or even prison time.
As for the companies themselves, take Enron and WorldCom, for instance—they've vanished, poof, gone.
So, before even considering some accounting trickery, remember what Warren Buffet once said: "It takes 20 years to build a reputation and five minutes to ruin it."
While the accrual basis and matching principle provide accountants with a way to manipulate revenue and expenses, that doesn't mean they can't be caught. It requires solid teamwork between executives and auditors.
After the fall of Arthur Andersen, not many auditors are willing to take that risk.
ARTICLE SOURCES
- What Is Channel Stuffing? How It Works, Purpose, and Legality by Adam Hayes. Investopedia. https://www.investopedia.com/terms/c/channelstuffing.asp. (accessed April 14, 2024)
- What’s Channel-Stuffing and Is It a Crime? MoloLamken. https://www.mololamken.com/knowledge-Whats-Channel-Stuffing-and-Is-It-a-Crime. (accessed April 14, 2024)
- Accounting fraud definition. Accounting Tools. https://www.accountingtools.com/articles/accounting-fraud. (accessed April 14, 2024)
- Why Is Depreciation Estimated? by Bradley James Bryant. Chron. https://smallbusiness.chron.com/depreciation-estimated-43396.html. (accessed April 14, 2024)
- The WorldCom Fraud That Changed Everything by John Siegel. floqast. https://floqast.com/blog/the-worldcom-fraud-that-changed-everything/. (accessed April 14, 2024)
