What Is the Matching Principle and Why Is It Important?

In short, the matching principle states that where expenses can be matched with revenues, we should do so because the benefits of an asset or revenue should be linked to the costs of that asset or revenue. Administrative salaries, for example, cannot be matched to any specific revenue stream. If a future benefit is not expected then the matching principle requires that the cost is treated immediately as an expense in the period in which it was incurred. Certain financial elements of business also benefit from the use of the matching principle.

When to Use the Matching Principle

By matching expenses with the related revenue, the Matching Principle ensures that a company’s income statement accurately reflects its profitability in a given period. If expenses were recognized in a different period than the related revenue, the income statement would not accurately reflect the company’s profitability. Note that although the sales commission is not paid until April, based on the matching principle, the sales commission is an expense for the month of March as it has been matched to revenue recognized in that month. The business calculates sales commissions on a monthly basis and pays its agents in the following month. The Internal Revenue Code (IRC) includes provisions requiring the matching of income and expenses for tax purposes. Section 451, which deals with income recognition, and Section 461, covering deductions, emphasize the importance of consistent application of the matching principle.

It is then deducted from accrued expenses in the subsequent period to prevent a fictitious loss when the representative is compensated. The matching principle also has a cause and effect relationship with financial transactions occurring from normal business operations. Each dollar or unit of currency spent must have an offset, such as wages paid or items purchased for the business. Sales entries contain sales to customers matched with the inventory cost for the item sold; materials purchased for sale how to complete and file form w are matched with the spent cash; and wages paid are matched with the liability owed to employees. The accrual accounting method uses the principle as a self-balancing tool to maintain the accuracy of the general ledger. Accrual accounting, supported by GAAP and IFRS, captures economic events as they occur, irrespective of cash flow.

Creative Accounting and Its Effects on Financial Reporting

Assume we have sold the goods to our customers amount $70,000 for the month of December 2016. Another example is that the salesman in your company could earn some commission due to their sales performance. Based on the Matching principle, the Cost of Goods Sold should record the period in which the revenues are earned. Sometimes store can’t collect the money and have to write off the receivable as a bad debt because it will never be collected. An adjusting entry would now be used to record the rent expense and corresponding reduction in the rent prepayment in June. For example, a business spends $20 million on a new location with the expectation that it lasts for 10 years.

The cost is not recognized in the income statement (also known as profit and loss or P&L) during the payment period but is recorded as an expense in the period when the goods or services are actually received. At that time, the amount is deducted from prepayments (assets) on the balance sheet. The principle is based on the accrual accounting method, which records transactions when they occur, not when the cash is received or paid. Under accrual accounting, revenues and expenses are recognized when they are earned or incurred, not necessarily when the cash changes hands.

The principle is at the core of the accrual basis of accounting and adjusting entries. If there’s no cause and effect relationship, then the accountant will charge the cost to the expense immediately. A deferred expense (also known as a prepaid expense or prepayment) is an asset representing costs that have been paid but not yet recognized as expenses according to the matching principle.

What Is the Historical Cost Principle (Definition and Example)

The business then disperses the $20 million in expenses over the ten-year period. If there is a loan, the expense may include any fees and interest charges as part of the loan term. This disbursement continues even if the business spends the entire $20 million upfront. It may last for ten or more years, so businesses can distribute the expense over ten years instead of a single year. The cash balance declines as a result of paying the commission, which also eliminates the liability. An additional similar example related to the Matching Principle is accrual salaries.

Matching and Costs which have no Future Benefit

For example, If the fixed assets amount estimated taxes: how to determine what to pay and when to $50,000 and depreciation for five years as the result of economic use. Then, the depreciation expenses amount to $10,000 per year should be recorded. The concept is that the expenses of fixed assets should not be recorded imitatively when we purchase.

• These accruals maintain the standards of the matching principle since all revenues will be matched with the expenses incurred to generate those revenues in the same period.
• By aligning expenses with the revenues they generate, the principle provides a comprehensive understanding of financial activities within a specific accounting period.
• For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.
• The accountant or other financial professional basically matches each financial gain to the costs it took to get there.
• Income statements are particularly impacted, as the principle ensures revenues and expenses are reported together, leading to an accurate depiction of net income.

Expense vs. cash timing

Subtract $30 in costs from the $40 in revenue, and the company has $10 in income. Meanwhile, under the LIFO inventory accounting method, it would deduct the cost of the last unit of inventory purchased, namely the unit purchased for $32 in November. For example, if goods are supplied by a vendor in one accounting period but paid for in a later period, this creates an accrued expense.

Legit Expenses That Reduce Tax in Books of Accounts

• For example, if goods are supplied by a vendor in one accounting period but paid for in a later period, this creates an accrued expense.
• An adjusting entry would now be used to record the rent expense and corresponding reduction in the rent prepayment in June.
• The Internal Revenue Code (IRC) includes provisions requiring the matching of income and expenses for tax purposes.
• The purpose of the matching principle is to maintain consistency in the core financial statements — in particular, the income statement and balance sheet.
• It is one of the guiding principles of accounting and is essential for accurate financial reporting.
• Note that although the sales commission is not paid until April, based on the matching principle, the sales commission is an expense for the month of March as it has been matched to revenue recognized in that month.

If the future benefit of a cost cannot be determined, it should be charged to expense immediately. This concept also makes extensive use of accruals and deferrals to balance general ledger accounts when no information has been posted to the accounts. Companies may experience a lag in posting certain expense items to their general ledger, such as utilities expenses, freight expenses, or payroll expenses.

Explore how the matching principle shapes accurate financial reporting and its crucial role in modern accrual accounting practices. The expense must relate to the period in which the expense occurs rather than on the period of actually paying invoices. For example, if a business pays a 10% commission to sales representatives at the end of each month. If the company has $50,000 in sales in the month of December, the company will pay the commission of $5,000 next January.

It’s not always possible to directly correlate revenue to spending in these cases. Expenses for online search ads appear in the expense period instead of dispersing over time. On a larger scale, you may consider purchasing a new building for your business. There’s no way to tell if a larger space or better location improves revenue. Because of this, businesses often choose to spread the cost of the building over years or decades.

Differences between management and tax accounting

This will result in a decrease in the cash account and, therefore, a negative cash flow. Even though the product was sold in year 2, it was sold on credit so no cash is received. This means it can be recognized as revenue on the income statement (the product was delivered to the customer), but can not be reported in the cash flow statement as no cash has been received. A positive cash flow cannot be reported until year 3 on the company’s financial statements.

This contrasts with cash accounting, which records transactions only when the cash is received or paid. Suppose a business produces a faulty batch of 500 units of a product which sells for 6.00 a unit and costs 2.00 a unit. If the units were not faulty the costs would be matched against sales of the product as part of the cost of goods sold (as described above). However, in this instance the units are faulty and will not be sold and therefore the business cannot expect a future benefit from the costs incurred. The matching principle requires that the costs are treated immediately as an expense in the current accounting period. There are situations in which using the matching principle can be a disadvantage.

As a concept it is used in many different settings to help professionals keep track of what is frf for smes frequently asked questions going in and what is coming out, and it can help companies and businesses make sound financial decisions. Accrued expenses are liabilities with uncertain timing or amount, but the uncertainty is not significant enough to classify them as a provision. An example is an obligation to pay for goods or services received, where cash is to be paid out in a later accounting period. Accrued expenses share characteristics with deferred income (or deferred revenue), except that deferred income involves cash received from a counterpart, while accrued expenses involve obligations to be settled later.

We want to match the period for when the costs have incurred in the relevant period. For the matching principle, we relate this to the period when a product or service is recognized as being sold (revenue recognition). The matching principle also states that expenses should be recognized in a “rational and systematic” manner. This is the key concept behind depreciation where an asset’s cost is recognized over many periods. There are some exceptions to the Matching Principle, particularly when it comes to long-term assets and liabilities.

Matching principle accounting ensures that expenses are matched to revenues recognized in an accounting period. For this reason the matching principle is sometimes referred to as the expenses recognition principle. Not all costs and expenses have a cause and effect relationship with revenues. Hence, the matching principle may require a systematic allocation of a cost to the accounting periods in which the cost is used up. Hence, if a company purchases an elaborate office system for $252,000 that will be useful for 84 months, the company should report $3,000 of depreciation expense on each of its monthly income statements.