Indicates that a corporation must disclose an expense on its income statement in the same period as the relevant revenues.
The matching concept is one of the most fundamental accounting principles. According to the matching principle, a corporation must disclose an expense on its income statement in the same period as the relevant revenues.
This principle is one of the most crucial accounting concepts under the accrual basis of accounting. This is because the accrual basis of accounting and correcting entries is linked to the principle.
If an item isn't directly related to revenue, it should be mentioned in the income statement in the prevailing accounting period in which it expires or is depleted. If the cost of that item in the future cannot be identified as a benefit, it should be charged to the expense as soon as possible.
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.
In some circumstances, such as when the purchase cost of a fixed asset is depreciated over several years, a systematic allocation of a cost across numerous reporting periods will be required. If no cause-and-effect relationship exists, charge the cost right away.
Because it requires that the complete effect of a transaction be recorded within the same reporting period, this is one of the most important ideas in accrual basis accounting.
This ensures that profit reporting is not artificially expedited or delayed at any time throughout the reporting period. Instead, when revenues are reported, they are disclosed along with all associated expenses.
The principle is an accounting concept that requires businesses to report expenses simultaneously as the revenues to which they are linked. For some time, revenues and expenses are matched on the income statement (e.g., a year, quarter, or month).
Let us define period and product costs to clarify the matching concept further.
Commissions, office supplies, and rent are examples of period costs that aren't directly related to the product. 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.
When they occur, they are merely referenced in the statement. Therefore, expenses must be documented in the timeframe of their occurrence rather than when the amount is paid according to the accounting matching concept.
Product costs refer to the expenses incurred during the product's manufacturing. The accrual or matching principle states that we should simultaneously calculate the cost of producing a commodity as we calculate the income from sold commodities.
For example, if a salesperson sells 200 copies of a book in January, the cost price of those 200 copies must be matched with the January income to determine the profit or loss.
The product costs generally include the direct material, direct labor, traceable variable, and traceable fixed costs to the product that is being manufactured.
The importance of matching concepts
The concept is critical for organizations to report their financial results properly. Its major goal is to eliminate any risk of misrepresentation over time.
Under the "Income Statement" fundamental equation, matched expenses and revenues operate as follows:
Revenues earned - incurred costs = Net earned profits.
This is because a company cannot generate sales or revenues without paying expenses like the cost of labor, raw materials, marketing expenses, selling expenses, administrative expenses, or other miscellaneous expenses.
Therefore, only reporting revenues for a given period without showing the costs that brought those revenues could distort the face of financial statements by either overstating or understating a company's profits, leading to overstatement or understatement.
It governs how a business should account for its expenses. The basic premise is that expenses should follow revenue.
However, matching the expenses to the earnings might sometimes be challenging. To avoid this, expenses can be divided into period and product costs.
Period costs are recorded on the financial statement as the company incurs them-for instance, office rent, salaries, and other administrative costs. Product costs, on the other hand, are easily linked to income.
Expenses such as direct material labor and plant overhead are included in product costs. The allocation method can be used by businesses to match such expenses to revenue.
Product costs that have yet to be matched to revenue are recorded as an asset on the balance sheet.
The income statement displays the product costs that account managers match to the revenue and current period costs. As a result, the concept directly impacts net profit or loss.
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.
For example, if the company made $60,000 in sales in December, it will pay $6,000 in commissions on January 15.
According to the principle, $6,000 in commissions must be disclosed on the December income statement, along with $60,000 in sales. It also stipulates that a current liability of $6,000 be included on the December 31 balance sheet.
This is known as an accrual, accomplished with an adjusting entry dated December 31 that debits $6,000 from Commissions expense and credits $6,000 to Commissions Payable.
(Without the matching concept and the adjusting entry, the corporation might report the $6,000 commission expenditure in January instead of December, when the expense and obligation occurred.)
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.
There isn't always a cause-and-effect relationship between costs and revenues. As a result of the principle, a systematic allocation of a cost to the accounting periods in which the cost is used up may be required.
As a result, if a corporation spends $252,000 on an expensive office system that will be effective for 84 months, the company should deduct $3,000 from each of its monthly income statements.
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.
A company's policy is to award every sales representative a 1% bonus on their quarterly sales. Now, if the company has four sales representatives, each of whom made $100,000 in sales in the first quarter of the year, they each receive a $1,000 bonus.
Because there are four of them, the company's total incentive expense will be $4,000 (4 $1000).
If, for example, the company paid the bonus in May, which is in the second quarter of the year, the matching concept requires the corporation to record this expense in the first quarter rather than the second because this spending is related to the first quarter's revenues.
Assume a corporation produces 100 books at the cost of $4,000. It then sells twenty copies for fifty rupees each, resulting in a profit of two thousand rupees.
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.
In other words, in matching principle accounting, the revenue for the given time must be examined first, followed by the expenses incurred to generate that revenue. 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.
A Law Firm pays a $4,000/month fixed salary to 6 of its consultants. The same Law Firm earned revenues of $230,000 and $180,000 in June and July, respectively. Therefore, the expense for the two months would be the same $24,000 ($4,000 × 6) as the salaries are fixed.
But the profits for the months of June and July would be $206,000 ($230,000 – $24,000) and $156,000 ($180,000 – $24,000) respectively. This is because the salary expense matches the revenues generated for the individual months.
Some other specific examples
Commissions, depreciation, bonus payments, wages, and the cost of items sold are all examples of the matching concept.
Commissions Matching Principle
On sales shipped and recorded in January, a salesman earns a 10% commission. The $1,000 commission is paid in February. Therefore, the commission expense should be recorded in January to be recognized in the same month as the connected transaction.
Matching Principle for Depreciation:
A corporation spends $500,000 on production equipment with a 10-year expected useful life. Therefore, it should depreciate the cost of the equipment at a rate of $50,000 per year for ten years, allowing the expense to be recognized throughout the entire useful life of the asset.
Employee Bonuses and the Matching Principle
A bonus plan pays a $60,000 incentive to an employee depending on measurable components of her performance over a year. In the next year, the bonus is paid. The bonus expense should be recorded within the year the employee received it.
Wage Equivalence Principle
Hourly employees' pay period finishes on April 28, although they continue to collect income until April 31, when they are paid on May 4. Therefore, wages earned between April 29 and April 31 should be recorded as an expense in April.
The Cost of Goods Sold Matching Principle
For $10,000, a corporation offers 100 units of a product. The cost of the goods sold is $4,000 for these units. Because revenue recognition and the cost of goods sold are so closely related, the corporation should recognize the entire $4,000 cost as an expense in the same reporting period as the sale.
The matching concept is a part of the accrual accounting technique. Investors like a smooth and normalized income statement that connects revenues and expenses rather than one that is unconnected.
By combining them, investors have a better understanding of the underlying economics of the firm. It should be noted, however, that the cash flow statement should be viewed in conjunction with the income statement.
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.
As a result, investors pay close attention to the company's cash balance and cash flow timing.
Using the matching concept has many advantages.
1. 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.
2. The profits reported under the principle are more consistent throughout reporting periods, reducing huge variations. This is especially true when it comes to depreciating the cost of fixed assets rather than charging the total cost of these assets to expense as soon as they are purchased.
3. It helps the income statement portray a more realistic picture of a company's operations.
There are times when applying the principle is counterproductive. It takes more effort from the accountant to record accruals to transfer expenses across reporting periods. Because it is relatively sophisticated, small firms without accountants may find it challenging to use.
1. In some circumstances, there is no cause-and-effect relationship between revenues and expenses, making it difficult to decide whether to stretch expense recognition over multiple reporting periods and how much to charge for expenses in each period.
2. It is difficult to predict the impact of continuing marketing expenditures on sales; it's common practice to charge marketing expenses as incurred.
The idea works well when it's simple to connect revenues and expenses via a direct cause-and-effect relationship. However, there are situations when that link is less evident, and estimates must be made.
Consider a corporation that decides to establish a new office headquarters to increase worker productivity.
There is no way to precisely quantify the timing and impact of the new office on sales; the company will depreciate the total cost over the usable life of the additional office space (measured in years).
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. Regardless of whether or not revenue is earned, the expense will persist.
Another scenario is if a business spends $1 million on web marketing.
Customers may take months or years to make a purchase. Thus it may not be possible to track the timeliness of the revenue that comes in.
In this situation, the marketing would be recorded on the income statement when the ads are displayed rather than when the revenues are collected.
Accounting for the Principle
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.
The commission expense is charged in this entry before the cash payment to the salesperson is made, as well as a liability in the same amount. The company pays the commission the following month and makes the following entry:
As a result of paying the commission, the cash balance decreases, and the liability is eliminated. It shows the working of the principle with the accrual basis of accounting. The cash decreased, and the liability increased with the same amount. It shows the double effect as well as the matching concept.
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.
More miniature goods are instead charged for expenses when they are incurred. This allows the accountant to make better use of their time while having no meaningful influence on the financial statements.
In a nutshell, no. When you employ the cash basis of accounting, the movement of cash triggers the recording of accounting transactions.
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.
Why is a matching concept useful in accounting, and which principle, accrual or matching concept, appeals to you more?
Accrual accounting uses the matching notion. Accrual accounting covers it. Revenues and expenses must be matched over the same period in accrual accounting. As a result, one cannot favor accrual accounting over the principle. They both complete and balance one another.
Following the principle in accounting has the following benefits:
- Equal Resource Allocation: Given the need to balance costs and revenues over the same period, the principles provide an equal distribution of firm assets. Depreciation is thus easily avoidable.
- Accurate Reporting: The principle ensures accuracy in accounting for expenditures and income.
- The Transparency of the Company's Finances: By adhering to the matching principle, the company's profits and losses are transparent to investors and other stakeholders.
There are many drawbacks to the matching notion, one of which is that estimation cannot be used. However, the principal's benefits exceed these drawbacks, which may be overcome with a little bit of common sense.
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Researched and authored by Deeksha Pachauri | LinkedIn
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