Matching Principle: Definition and Examples

Liabilities are recorded on the balance sheet at the end of the accounting period. Expenses are recorded on the income statement in the same period that related revenues are earned. 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.

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Commission

This comparison will give the net profit or loss for that particular accounting period. Most businesses record their revenues and expenses on an annual basis, which happens regardless of the time of receipts of payments. According to the matching principle of accounting, the incomes or revenues of a particular period must be matched with the expenses of that particular period. Accrual basis of accounting records revenues and expenses even when cash is not yet received or paid.

For example, if expenses are not recorded until payment is made, then it may case understatement of expenses in one period and overstatement of expenses in the next. The matching principle requires that a company tie revenue it generates during a given period — say a month, quarter or fiscal year — with expenses it incurred to reap that revenue. The principle also can apply to a project or long-term initiative — say, the construction of a highway. For ensuring consistency in financial statements, businesses follow the matching principle. If you recognize the expenses at the wrong time, you may get the inaccurate financial report of a business. The matching principle helps you to balance the cost over a period once you recognize it at the right time. When businesses interpret financial statements, those statements must be calculated and prepared in a certain manner to abide by proper accounting principles.

What Effects Do Double-Entry Accounting Systems Have on Financial Statements?

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Certain business financial elements benefit from the use of the matching principle. Assets (specifically long-term assets) experience depreciation and the use of the matching principle ensures that matching is spread out appropriately to balance out the incoming cash flow. A Deferred expense is an asset used to costs paid out and not recognized as expenses according to the matching principle.

Inventory Costing Systems

This matches costs to sales and therefore gives a more accurate representation of the business, but results in a temporary discrepancy between profit/loss and the cash position of the business. Prepaid expenses, such as employee wages or subcontractor fees paid out or promised, are not recognized as expenses; they are considered assets because they will provide probable future benefits. As a prepaid expense is used, an adjusting entry is made to update the value of the asset. In the case of prepaid rent, for instance, the cost of rent for the period would be deducted from the Prepaid Rent account. When expenses are recognized too early or late, it can be difficult to see where they result in revenue.

In this case, let’s say you use it to bike to work and it’s saved you on gas. In this circumstance, you should charge the bike’s cost to the depreciation https://online-accounting.net/ expense of $20 per year, adding up to 10 years. The computer is expected to last 10 years, meaning it will produce projects for the projected decade.

Matching Principle Law and Legal Definition

An example is a commission earned at the moment of sale by a sales representative who is compensated at the end of the following week, in the next accounting period. 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. According to the revenue recognition principle, revenue must be recognized and recorded on the income statement when it’s earned or realized. Businesses don’t have to wait for the cash payment to be received to record this sales revenue. An example of revenue recognition would be a contractor recording revenue when a single job is complete, even if the customer doesn’t pay the invoice until the following accounting period.

In such a case, the marketing expense would appear on the income statement during the time period the ads are shown, instead of when revenues are received. It should be mentioned though that it’s important to look at the cash flow statement in conjunction with the income statement. define matching principle If, in the example above, the company reported an even bigger accounts payable obligation in February, there might not be enough cash on hand to make the payment. For this reason, investors pay close attention to the company’s cash balance and the timing of its cash flows.

Company

When the company is able to match their expenses to the time when revenues are earned, it provides investors a clearer idea of the financial performance of the company and whether or not they are able operate efficiently. Inventory costing systems are the systems used to determine the cost of producing and storing a company’s inventory prior to the inventory being sold for revenue.

There are many ways that companies can determine inventory costs, such as FIFO , LIFO , and weighted average. Regardless of the method selected by the organization, it needs to follow the matching concept to ensure that inventory costs are expensed when the products are sold. If your company’s pay period ends on Dec. 25 and you don’t get paid until Jan. 5, this expense will be recorded in the December income statement for the wages you earned from Dec. 25 to Dec. 30. This is because you continued to earn wages past the pay period—in this case, the final days at the end of December. Because you will continue to earn wages through the end of the month and will be paid Nov. 3, this expense needs to be recorded in the October income statement for the wages earned between Oct. 21 and Oct. 31.

This can potentially distort financial statements and give investors an unclear view of the overall financial position. For example, if you recognize an expense too early it reduces net income. On the other hand, if you recognize it too late, this will raise net income. Investors typically want to see a smooth and normalized income statement where revenues and expenses are tied together, as opposed to being lumpy and disconnected. By matching them together, investors get a better sense of the true economics of the business. The principle is at the core of the accrual basis of accounting and adjusting entries. The cause and effect relationship is the basis for the matching principle.

• However, there are a lot of expenses that must be paid in the months leading up to January that will actually take place in 2015, the prior accounting period.
• Violating the matching principal can result in inaccurate financial reports when costs are not matched to the revenue they generate.
• 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.
• It is important to match expenses with revenues because net income, i.e. the net amount earned in a period, is calculated by subtracting expenses from revenues.
• Discover examples of how to use the matching concept in inventory costing systems, recording accrued interests, and in warranties.
• They are categorized as current assets on the balance sheet as the payments expected within a year.