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What is the Matching Principle in Accounting? Explained

The realization and accrual concepts are essentially derived from the need to match expenses with revenues earned during an accounting period. Most businesses record their revenues and expenses on an annual basis, which happens regardless of the time of receipts of payments. As a result, revenue is recorded when money is received, and supplier bills are recorded when money is paid. When you employ the cash basis of accounting, the principle is disregarded. Team members will receive a $1,000 bonus next year on March 15th, 2023. Since the expense is only indirectly related to revenue, the matching principle requires that the company records the bonus expense before the new year.

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The second aspect is that the full cost of those items must be included in that particular period’s income statement. First, that the revenue has been earned in the period in which it is included in the income statement. The matching principle of accounting is a natural extension of the accounting period principle. Because applying it to immaterial things might be time-consuming, firm controllers rarely use it. Even if the underlying effect affects all three months, it may not make sense to produce a journal entry that spreads the recognition of a $100 supplier invoice over three months. For example, if the office costs $10 million and is expected to last ten years, the corporation will set aside $1 million in straight-line depreciation each year for the next ten years.

Balance Sheet

Consequently, the company does not have to wait for the payment from the clients to record and recognize the revenue. You have probably heard that “It takes money to make money.” A business person contributes financial resources and hopefully uses them effectively to generate even more value. The looks at a window of time in terms of how much income came in and how much it cost to generate that income. It compares how much came in in sales in a month vs. how much was spent.

Benefits of the Matching Principle

It also results in more consistent reporting of profits across reporting periods, minimizing large fluctuations. This is especially important in relation to charging off the cost of fixed assets through depreciation, rather than charging the entire amount of these assets to expense as soon as they are purchased. The matching principle  requires that revenues and any related expenses be recognized together in the same reporting period. Thus, if there is a cause-and-effect relationship between revenue and certain expenses, then record them at the same time. In some cases, it will be necessary to conduct a systematic allocation of a cost across multiple reporting periods, such as when the purchase cost of a fixed asset is depreciated over several years. If there is no cause-and-effect relationship, then charge the cost to expense at once.

The matching principle is a key component in accrual accounting

So therefore, these costs aren’t directly linked to the product or service. Or, we can say period costs are those expenses not expensed for producing the good or service. Revenues and related expenses must be recognized under the same reporting period. Record them simultaneously if revenue and certain expenses have a cause-and-effect relationship. According to the matching principle, a corporation must disclose an expense on its income statement in the same period as the relevant revenues.

Is the Matching Principle Used Under the Cash Basis of Accounting?

An example is an obligation to pay for goods or services received from a counterpart, while cash for them is to be paid out in a later accounting period when its amount is deducted from accrued expenses. Prepaid expenses are not recognised as expenses but as assets until one of the qualifying conditions is met, resulting in a recognition as expenses. If no connection with revenues can be established, costs are recognised immediately as expenses (e.g., general administrative and research and development costs). If an expense is not directly tied to revenues, the expense should be reported on the income statement in the accounting period in which it expires or is used up. If the future benefit of a cost cannot be determined, it should be charged to expense immediately.

  1. This is what you will do by making adjustingentries, and this will ensure that your financial statement numbers are current and correct.
  2. Another example of an expense linked to sales through a cause and effect relationship is a retailer’s or a manufacturer’s cost of goods sold.
  3. The business uses the straight line depreciation method and calculates the annual depreciation expense as follows.
  4. The allocation method can be used by businesses to match such expenses to revenue.

Luckily, the products sell out on September 5th for a revenue of $6,000. Both adjusted entries and the matching principle help organize information already in your books. In other words, you don’t need an industrial-grade eraser to make an entry. Let’s  assume that in 2015, Company ABC generated $2,000,000 in revenue.

It purchases a large appliance from wholesalers for $5,000 and resells it to a local restaurant for $8,000. At the end of the period, Big Appliance should match the $5,000 cost with the $8,000 revenue. Using an accrual entry to record items using the principle is typical. The following is an example of a commission payment entry; this will make you understand it better. It reduces the danger of misreporting whether a company made a profit or a loss during any given reporting period. This is especially essential when a company’s profit margins are close to breakeven.

As a result, implying that the company lost two thousand rupees is incorrect, given that the company invested four thousand rupees in the production of all items. Businesses primarily follow the matching principle to ensure consistency in financial statements. Per the matching principle, expenses are recognized once the income resulting from the expenses is recognized and “earned” under accrual accounting standards. The matching principle is a part of the accrual accounting method and presents a more accurate picture of a company’s operations on the income statement. This, of course, is a simplified example, and there are several challenges in attempting to cash flow match a liability stream in the real world.

This revenue was generated by the activities of the sales agents and the what does an accountant do in accounting requires the matching of the sales commission expense to this revenue. The matching principle, also called the “revenue recognition principle,” ensures that expenses are recorded in the correct period by relating them to the revenues earned in the same period. As a result of paying the commission, the cash balance decreases, and the liability is eliminated.

The image below summarizes how the matching principle is part of the accrual basis of accounting. A business selects a time period for its accounting (year, quarter, month etc) and uses the revenue recognition principle to determine the revenue for that period. Based on this time period and revenue recognized the matching principle is used to determine the expenses to be included. Not all costs and expenses have a cause and effect relationship with revenues.

If any goods have been sold in a particular period, the first test is to ensure that they have been delivered or otherwise placed at the disposal of the buyer. According to the principle, even though the entire cost of manufacturing was four thousand rupees, the profit would be one thousand rupees despite the revenue of two thousand rupees. It then sells twenty copies for fifty rupees each, resulting in a profit of two thousand rupees. One of the most straightforward examples of understanding the matching principle is the concept of depreciation.

As a result, investors pay close attention to the company’s cash balance and cash flow timing. If the corporation reported an even larger account payable liability in February, as in example 3 above, there might not be enough cash on hand to fulfill the payment. If a cost’s future benefit cannot be calculated, it should be charged to the expense right away. The entire cost of a television advertisement displayed during the Olympics, for example, will be charged to advertising costs in the year the ad is shown. Assume that a company’s sales are made solely by sales representatives who are paid a 10% commission. Commissions are paid on the 15th of the month succeeding the month in which the sales were made.

The matching principle requires that the costs are treated immediately as an expense in the current accounting period. The matching principle seeks to create a correlation between revenues and expenses by ensuring that all revenue earned in an accounting period is also recorded as an expense for that same period. This allows businesses to link revenues and expenditures so that the net income can be accurately represented on financial statements. The goal of this is to properly analyze a company’s performance over time rather than at one point in time.

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