Matching Principle is a common accounting concept. Under this, a company should report an expense in the income statement in the same period when it earns the revenue. Put it simply, a company must recognize expenses on the financial statements when it produces the revenue as a result of those expenses. So, an expense that does not directly relate to the revenue should come in the income statement in the accounting period in which the company benefits from it.
Use of such a principle helps a company present an accurate picture of the operations. Since this principle matches the expense to revenue, it helps in building investors’ trust that the numbers are unreal.
Matching principle associates with the accrual basis of accounting and adjusting entries, and is part of the GAAP (Generally Accepted Accounting Principles). The principle is overseen by four organizations – Government Accounting Standards Board (GASB), Securities and Exchange Commission (SEC), Financial Accounting Standards Board (FASB) and American Institute of Certified Public Accountants (AICPA).
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Elements of Matching Principle
Matching principle is all about how a company should recognize its expenses. The underlying theory is that the expense should follow revenue. However, at times, it becomes difficult to match all the expenses to the revenue. Therefore, to overcome this, one can segregate expenses in two different categories – period and product costs.
Period costs are shown on the financial statement as and when the company incurs them. For example, rent for the office, officer salaries, and other administrative expenses. On the other hand, one can easily relate product costs with revenue. Product costs include expenses such as direct material labor and factory overhead. Companies may use the allocation method to match such expenses to revenue.
Product costs that the company is yet to match to the revenue come on the balance sheet as an asset. The income statement shows the product costs that the account managers match to the revenue and the period costs of the current period. So, it means that the matching principle directly affects the net profit or loss.
A company pays its employees an annual bonus during the fiscal year. As per the policy, the employees get 5% of revenues that the company generates over the year. The company pays the bonus in January every year. For 2018, revenue for the company was $100 million. Therefore, it should pay its employees a bonus of $5 million in January 2019. Though the company does not pay the bonus until the following year, as per the matching principle this expense should come in the income statement of 2018.
At the end of 2018, a bonus payable balance of $5 million would come on the balance sheet. The cash would be $5 million higher to ensure that the balance sheet tallies. In January, when the company pays the bonus of $5 million, there would be no impact on the income statement. The cash balance in the balance sheet would come down by $5 million and the accounts payable balance will also come down by $5 million. Thus, the balance sheet will continue to balance.
Why Matching Principle?
Before the adoption of the matching principle, expenses were shown in the income statement irrespective of whether they relate to the current accounting period or not. This resulted in the non-recognition of expenses.
Companies use the matching principle concept to ensure consistency in all their financial statements, including income statement, balance sheet, and cash flow statement. If a company misses on an expense or skips putting it on the statement, it would give an inaccurate picture of the financial position of the business. For instance, a company that adds the expense earlier than appropriate will show a lower net income. Similarly, if a company recognizes the same expense later than the appropriate time, it will result in higher net income.
Use of depreciation is a major byproduct of the matching principle. Depreciation helps to ensure that the cost of a fixed asset does not impact the profit & loss at once. Instead, the cost matches with the asset’s economic benefits over several accounting periods.
Matching vs. Accruals vs. Cash Basis
In cash basis, a company recognizes the revenues and expenses when it pays or gets cash. On the other hand, the accrual basis and matching principle sound similar and one often use them interchangeably in the accounting world. However, there is a big difference between the two. One recognizes revenues and expenses under accrual-based accounting at the time of the event irrespective of the cash inflows or outflows. On the other hand, under the matching principle, one matches revenue with the expenses.
Though matching and accrual-based accounting sound similar, the matching concept is better than the accrual basis. For instance, a company would recognize the estimated tax expense under accrual basis in the current accounting period despite the actual settlement happening in the subsequent period. The matching principle would require the recognition of deferred tax in the accounting period in which the temporary differences occur in order to ‘match’ accounting profits with tax charge recognized in an accounting period to the extent of the temporary differences.
At times, a company might decide not to apply the matching principle for certain expenses that are small. For instance, if a company with billions of dollar in revenue buys an office item worth $1000 whose productive life is over five years may choose not to apply matching principle. A matching concept will require the company to spread the cost of the item to five years to match the revenue it generates. However, for a billion-dollar company carrying this petty amount for five years could cause be irrelevant.
Let’s take another example. Suppose a company invests $10,000 in online marketing. It becomes very difficult to track the revenue that comes because of the marketing campaign. So, the marketing expense would appear in the income statement when the ads are shown.
Matching principle works well when it is easy to relate to revenues and expenses. But, it is not always easy to relate an expense to revenue. Under such circumstances, a company must follow a systematic approach.1,2