What is the Matching Principle in Accounting? Explained

If an expense is not directly tied to revenues, the expense should be reported on the income statement in the accounting period in which it expires or is used up. If the future benefit of a cost cannot be determined, it should be charged to expense immediately. If revenues and expenses are mismatched across periods, the financials may tell an inaccurate earnings story. But with proper matching, managers can correctly assess performance trends over time. This facilitates data-driven decisions about pricing, what is the matching principle budgets, growth plans, and more.

• With the help of quite some ratios, the company’s performance is determined, which helps investors decide on investments.
• The second aspect is that the full cost of those items must be included in that particular period’s income statement.
• Accrued expenses are liabilities with uncertain timing or amount, but the uncertainty is not significant enough to classify them as a provision.
• If revenues and expenses are mismatched across periods, the financials may tell an inaccurate earnings story.
• Assume we have sold the goods to our customers amount $70,000 for the month of December 2016.
• The cash balance declines as a result of paying the commission, which also eliminates the liability.

Why is understanding matching principle important?

A retailer’s or a manufacturer’s cost of goods sold is another example of an expense that is matched with sales through a cause and effect relationship. To illustrate the matching principle, let’s assume that a company’s sales are made entirely through sales representatives (reps) who earn a 10% commission. The commissions are paid on the 15th day of the month following the calendar month of the sales. For instance, if the company has $60,000 of sales in December, the company will pay commissions of $6,000 on January 15.

Accrued expenses

By matching revenues and expenses to the period in which they occurred, the matching principle helps avoid distortions in financial reporting. It provides a better view of real profitability in each period compared to cash basis accounting. Adhering to the matching principle is necessary for producing GAAP-compliant financial statements. The matching principle states that expenses should be recorded in the same accounting period as the revenue they helped generate. Rather than immediately expensing costs as they are incurred, costs are capitalized on the balance sheet and gradually expensed over time as revenues are earned.

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• Adhering strictly to cash flows makes financial analysis and long-term planning more difficult since timing differences between cash transactions and underlying business activities can skew financial statements.
• In short, the matching principle states that where expenses can be matched with revenues, we should do so because the benefits of an asset or revenue should be linked to the costs of that asset or revenue.
• Shaun Conrad is a Certified Public Accountant and CPA exam expert with a passion for teaching.
• The matching principle, also called the “revenue recognition principle,” ensures that expenses are recorded in the correct period by relating them to the revenues earned in the same period.
• The depreciation expense arises due to a reduction in value of a long term asset caused by its limited useful life.

But by utilizing depreciation, the Capex amount is allocated evenly until the PP&E balance reaches zero by the end of Year 10. As shown in the screenshot below, the Capex outflow is shown as negative $100 million, which is an outflow of cash used to increase the PP&E balance. Let’s say a company just incurred $100 million in Capex to purchase PP&E at the end of Year 0. When a company acquires property, plant & equipment (PP&E), the purchase — i.e. capital expenditures (Capex) — is considered to be a long-term investment. Take self-paced courses to master the fundamentals of finance and connect with like-minded individuals.

Accounting Ratios

This matching of expenses and revenues impacts the balance sheet in a few key ways. So in summary, the matching principle creates a logical connection between revenues and expenses to give the most transparent view of a company’s profitability. Companies defer or accrue expenses on their balance sheet over time so that costs can be matched to related revenues in the appropriate reporting period.

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For example, when accounting periods are monthly, an 11/12 portion of an annually paid insurance cost is recorded as prepaid expenses. Each subsequent month, 1/12 of this cost is recognized as an expense, rather than recording the entire amount in the month it was billed. The remaining portion of the cost, not yet recognized, stays as prepayments (assets) to prevent it from becoming a fictitious loss in the billing month and a fictitious profit in other months. For example, if goods are supplied by a vendor in one accounting period but paid for in a later period, this creates an accrued expense.

Similarly, cash paid for goods and services not received by the end of the accounting period is added to prepayments. This practice prevents the expense from being recorded as a fictitious loss in the payment period and as a fictitious profit in the period when the goods or services are received. The cost is not recognized in the income statement (also known as profit and loss or P&L) during the payment period but is recorded as an expense in the period when the goods or services are actually received. At that time, the amount is deducted from prepayments (assets) on the balance sheet.