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The Matching Principle in Accounting

The principle works well when it’s easy to connect revenues and expenses via a direct cause and effect relationship. There are times, however, when that connection is much less clear, and estimates must be taken. This concept applies to all kinds of business transactions involving assets, liabilities and equity, revenue and expense recognition. 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.

  1. This principle ensures accurate financial reporting by requiring revenue to be recorded in the accounting period in which it is earned.
  2. Per the matching principle, expenses are recognized once the income resulting from the expenses is recognized and “earned” under accrual accounting standards.
  3. The idea works well when it’s simple to connect revenues and expenses via a direct cause-and-effect relationship.
  4. Since there is an expected future benefit from the payment of rent the matching principle requires that the cost is spread over the rental period.
  5. In February 2019, when the bonus is paid out there is no impact on the income statement.
  6. The expense must relate to the period in which the expense occurs rather than on the period of actually paying invoices.

In 2018, the company generated revenues of $100 million and thus will pay its employees a bonus of $5 million in February 2019. Adjusting entries, discussed next, help do the job of matching the June revenue with the June expenses by “chopping” off amounts of transactions that do not belong in a given month. This will require two initial journal entries in the month of January, followed by a recurring journal entry for February through December. For the month of April, your company had sales in the amount of $27,000. This means that you owe your sales staff a total of $4,050 in commissions for the month of April. If Jim didn’t accrue the $900 in January, his sales of $9,000 would be reported in January, and the related commission expense would be reported in February.

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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. In February 2019, when the bonus is paid out there is no impact on the income statement. The cash balance on the balance sheet will be credited by $5 million, and the bonuses payable balance will also be debited by $5 million, so the balance sheet will continue to balance.

The first journal entry is made to record the initial rent payment in the amount of $15,000. Instead of expensing this directly to rent, you will record it as prepaid rent. By accruing the $900 in January, Jim will ensure that he is in compliance with the matching principle of reporting expenses in the same time period as sales. Simply put, revenue recognition implies the earning of revenue by a business. When a company has received the payment in their account, it is called revenue recognition. Being a part of GAAP – Generally Accepted Accounting Principles, the matching principle determines the causal relationship between spending and earnings.

Examples of the Matching Principle

The revenue recognition principle requires revenue to be recognized when it is earned, not when payment is received. This principle ensures accurate financial reporting by requiring revenue to be recorded in the accounting period in which it is earned. Together with the time period assumption and the revenue recognition principle the matching principle forms a necessary part of the accrual basis of accounting. The alternative method of accounting is the cash basis in which revenue is recorded when received and expenses are recorded when paid.

This fact is the fundamental of Accrual accounting which uses the matching principle. If there is no causal link between the expense and future revenue, it may be recorded immediately without adjusting entries. With businesses across the globe relying on this concept, they must also figure out a way to report and record it. In other words, they need to apply the matching principle of accounting, which says https://simple-accounting.org/ that to generate revenue, businesses have to incur expenses. 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. 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.

The second fact is that all costs that have been incurred for the purpose of earning the revenue should be included in the expenses for the period in which the credit for the income is taken. Like the payroll accrual, this entry will need to be reversed in May, when the actual commission expense is paid. However, the commissions are not due to be paid until May, so you will need to accrue the $4,050 for the month of April since the expense is clearly tied to the sales revenue that was earned in April.

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. There isn’t always a cause-and-effect relationship between costs and revenues. As a result common components of grant proposals of the principle, a systematic allocation of a cost to the accounting periods in which the cost is used up may be required. According to the principle, $6,000 in commissions must be disclosed on the December income statement, along with $60,000 in sales.

The alternative is reporting the expense in December, when they incurred the expense. The matching principle or matching concept is one of the fundamental concepts used in accrual basis accounting. Matching principle accounting ensures that expenses are matched to revenues recognized in an accounting period. For this reason the matching principle is sometimes referred to as the expenses recognition principle.

It helps the income statement portray a more realistic picture of a company’s operations. 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. 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. The concept is critical for organizations to report their financial results properly. Its major goal is to eliminate any risk of misrepresentation over time.

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

For example, when managing revenue, matching principle usage ensures that any expense incurred in the production of that revenue is properly accounted for in the month that the revenue is generated. Business expense categories such as prepaid expenses use the matching principle in similar fashion as depreciation. For example, in January, your business prepaid annual rent in the amount of $15,000. Your current pay period ends on April 24, but your next pay date is May 1. The amount of wages your employees earn between April 24 and May 1 amount to $4,150.

The matching principle, then, requires that expenses should be matched to the revenues of the appropriate accounting period and not the other way around. In such cases, the careful determination of such expenses has to be made and appropriate adjustments will be required in order to determine the proper profits (or loss) for the current accounting period. Using the matching principle, costs are also properly accounted for, resulting in more accurate financial statements.

The customer may not make a purchase until weeks, months, or years later. It’s not always possible to directly correlate revenue to spending in these cases. Expenses for online search ads appear in the expense period instead of dispersing over time. 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. Using an accrual entry to record items using the principle is typical.

Accounting for the Matching Principle

By using the belt in the production process, the belt will be providing monetary benefits to your business. Let’s  assume that in 2015, Company ABC generated $2,000,000 in revenue. Read on to learn how HighRadius’ Autonomous Accounting Software helps you get rid of manual matching processes that lead to reporting inaccuracies. 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. A company’s policy is to award every sales representative a 1% bonus on their quarterly sales.

There’s no way to tell if a larger space or better location improves revenue. There is no direct relationship between these factors and a new building. Because of this, businesses often choose to spread the cost of the building over years or decades. 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). By combining them, investors have a better understanding of the underlying economics of the firm.

Recognizing expenses at the wrong time may distort the financial statements greatly. A business may end up with an inaccurate financial position of its finances. The matching principle helps businesses avoid misstating profits for a period. As a result of paying the commission, the cash balance decreases, and the liability is eliminated.