The matching principle is a crucial concept in accounting which states that the revenues and any related expenses are realized and recognized in the same accounting period. In other words, if there is a cause and effect relationship between revenue and expenses, they should be recorded at the same time. This would also mean that expenses are not recorded when they are paid and will be recognized when their corresponding revenues are recorded.
Overall, expenses can be broken into two major categories – product and period costs. Product costs can be directly attributable to the goods or services delivered by the company and therefore will be recognized when a sale is recorded. Period costs do not necessarily have corresponding revenues. Administrative expenses, for instance, do not have a corresponding revenue stream and therefore are recorded in the current period.
The matching principle also calls for expenses to be recognized in a “rational and systematic” manner. This is the reason why an asset’s depreciation is split over the useful life of it and recognized over many periods instead of being recorded as a lump sum in just one period.
Benefits of the Matching Principle
The matching principle relates to the accrual accounting system and therefore presents a more reliable picture of the financial statements of a company.
The matching principle helps to normalize and smooth out the income statement. Otherwise, the company income statements would not make much sense if it were to recognize some of its revenues in one period and its related expenses in another. In this case, the company would be overstating the profitability in one period and understating the profitability in another. Thus, the matching principle will ensure that the income statement is not disconnected and that the investors have a better sense of the true profitability of the business.
It is important for the investors to also study the cash flow statement along with the income statement to get a holistic picture of the company’s operations.
Challenges of the Matching Principle
When there is a direct cause and effect relationship present between the revenues and expenses, this principle will be easy to implement. However, there are times when this relationship might not be that straightforward.
For instance, a company decides to build a new office building that will improve the productivity of its employees. There is no direct way of attributing this cost to the increased revenues resulting from the increased productivity of the employees. Therefore, the company will depreciate the cost of the building over its useful life.
Another example is of a company that pays for online marketing. The increased incremental revenue due to the marketing effort cannot be allocated directly with the cost since both the timing and amount is unknown. In this case, the online marketing spend will be treated as an expense on the income statement for the period the ads are shown in, instead of when the resulting revenues are received.
Matching Principle Examples
Some of the examples that explain the matching principle in further detail are given below:
Apple buys a piece of machinery for $100,000 in its Thailand factory. The useful life of this equipment is 10 years and it is expected that it will produce cell phones for this at least this period. Therefore, as per the matching principle, the rational and systematic approach would be to depreciate the machinery over its useful life.
Dawlance Trading Company sells kitchen appliances in a small town. It buys inventory worth $6,000 and sells it to a local restaurant for $9,000. At the end of the accounting period, Dawlance Trading Company should match the cost of inventory to the sales.
General Electric makes $60 million in revenue for an accounting period. It decides to announce and pay a dividend. Even though the bonus is not expected to be paid before the next accounting period, the company will realize this expense along with the corresponding revenues.
Company XYZ sales are made by sales representatives who take a 10% commission. The commissions are paid in the middle of each month, i.e. 15th day of each month. The company sales are $80,000 in March 2020 and the total commissions paid on 15th March amount to $8,000 out of which $3,000 are related to the previous month.
- The commission payable balance of $3,000 carried forward from the previous month should be debited and cash credited.
- The remaining commission paid out of $5,000 relates to the commissions pertaining to sales of this month till 15th March.
- The commission that is payable for this month from 15th to the 30th for which an adjusting entry will be made is $3,000.
Therefore, the total commission expense related to the month is $8,000. This is the addition of $5,000 already paid and the $3,000 that are still in payables and will be paid out on the 15th of next month.