The Matching Principle in Accounting What You Need to Know

In other words, it formally acknowledges that business must spend money in order to earn revenue. 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 matching principle works well in cases where revenues and expenses are clarified. But, there are times when the expenses will apply to more than one area of revenue, or it could even be vice versa.

• The realization and accrual concepts are essentially derived from the need to match expenses with revenues earned during an accounting period.
• The following is an example of a commission payment entry; this will make you understand it better.
• While accrual accounting is not a flawless system, the standardization of financial statements encourages more consistency than cash-based accounting.
• The cash balance declines as a result of paying the commission, which also eliminates the liability.
• This accounting concept states that only financial transactions will find a place in accounting.

This is because the accrual basis of accounting and correcting entries is linked to the principle. 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. Companies cannot generate sales or revenue without incurring raw material costs, labor costs, marketing costs, selling, administrative, and other miscellaneous costs, so they display only income for a specific period.

Objectivity Concept

The related revenue item is recognized, while cash for them is to be received later when its amount is deducted from accrued revenues. The accrual method of accounting requires you to record income whenever a transaction occurs (with or without money changing hands) and record expenses as soon as you receive a bill. In action, you might record income long before you receive payment.

• Sometimes, expenditures are incurred either in advance or subsequent to the accounting period even though they relate to expenses for goods or services sold during the current accounting period.
• Read on to understand the significance of the matching concept in accounting, the steps involved, the common challenges in the process, and some tips to improve the process.
• Since the expense is only indirectly related to revenue, the matching principle requires that the company records the bonus expense before the new year.
• This is because a company cannot generate sales or revenues without paying expenses like the cost of labor, raw materials, marketing expenses, selling expenses, administrative expenses, or other miscellaneous expenses.
• The matching principle is an accounting principle that governs how revenues and expenses are recorded.

Let’s look at an example of how the matching principle helps a company understand the indirect costs of a new piece of equipment that depreciates over time. Accrual-based accounting is one of the three accounting methods you can use as a small business owner. The two other accounting methods are cash-basis and modified cash-basis accounting. An accountant will recognize the best accounting software for auto repair shop both expenses and revenue and then correlate even though cash flow runs inconsistently. For example, based on a cash basis, the revenue amount of $70,000 is recognized only when the cash is the receipt. Based on the Matching Principle, even the commission is paid in January, but the commission expenses must be recognized and recorded in December 2016.

In 2018, the company generated revenues of $100 million and thus will pay its employees a bonus of $5 million in February 2019. The going concern concept assumes that a business will continue to operate indefinitely. So it assumes that for the foreseeable future the business will not be winding up. This leads to the assumption that the business will not have to sell its assets any time soon and it will meet all its obligations as well. If a business that does landscaping has completed the work of building a swimming pool at a farmhouse, the business has earned the fee, irrespective of when the customer will release the payment for that job.

The concept is critical for organizations to report their financial results properly. Its major goal is to eliminate any risk of misrepresentation over time. The product costs generally include the direct material, direct labor, traceable variable, and traceable fixed costs to the product that is being manufactured. For example, the entire cost of a television advertisement that is shown during the Olympics will be charged to advertising expense in the year that the ad is shown. The matching concept is crucial for organizations to disclose their financial results properly.

Steps to Prepare a Journal Entry

If the cost of that item in the future cannot be identified as a benefit, it should be charged to the expense as soon as possible. A deferred expense (prepaid expense or prepayment) is an asset used to costs paid out and not recognized as expenses according to the matching principle. In the case of depreciation, the expense is recognized over the asset’s useful life rather than in the period in which the asset was acquired. This allows for better matching of expenses to the revenues generated by the asset over its useful life. Another case in point is a business that pays for online marketing. The increased incremental revenue resulting from the marketing effort cannot be directly allocated with the cost because both the timing and amount are unknown.

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

There is a need for the accounts department of a business to come up with estimates in cases where no clear correlation exists between revenues and expenses. A business will purchase office supplies for the employees that could be stationery items. While these notebooks, pens, staplers and staple pins are essential, they cannot be correlated with revenue. As a result, revenue is recorded when money is received, and supplier bills are recorded when money is paid. When you employ the cash basis of accounting, the principle is disregarded. Depreciation distributes the asset’s cost over its expected life span according to the matching principle.

Full Disclosure Concept

The policy is to pay 5% of revenues generated over the year, which is paid out in February of the following year. To further explain the matching concept, let us define period costs and product costs. This concept states that all relevant information will be disclosed in the accounting statements. A lot of external users depend on these financial statements for their information to make investing decisions. So no information/transactions etc of relevance to anyone of them will be omitted from these statements for the benefit of the company.

So, the expense and the revenue will be booked in September, when the revenue was generated. Two examples of the matching principle with expenses directly related to revenue are employee wages and the costs of goods sold. The matching principle (also known as the expense recognition principle) is one of the ten Generally Accepted Accounting Principles (GAAP). And, the matching principle is the driving force of accrual accounting.

The first question you should ask when using the matching principle is whether or not your expenses are directly or indirectly related to generating revenue. In December 2016, the salesman could earn 2,000$, but the commission payment will be payable in January of the following year. The idea works well when it’s simple to connect revenues and expenses via a direct cause-and-effect relationship. However, there are situations when that link is less evident, and estimates must be made. If a cost’s future benefit cannot be calculated, it should be charged to the expense right away.

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. This principle is an effective tool when expenses and revenues are clear. However, sometimes expenses apply to several areas of revenue, or vice versa. Account teams have to make estimates when there is not a clear correlation between expenses and revenues.

Suppose a software company named Radius Cloud sells a license for $5,000 that costs $1,000 to develop. The cost of goods sold is $1,000, which should be recognized in the same period as the revenue is recognized, aligning with the matching principle. Understanding the matching principle is crucial for producing accurate financial reports, but manual implementation can be time-consuming, error-prone, and complex. According to Gartner, 86% of finance executives aim to achieve a faster, real-time close by 2025, with more than half of respondents already investing in general ledger technology and workflow automation. Moreover, 70% of companies that have automated more than one-fourth of their accounting functions report moderate or substantial ROI. While accrual accounting is not a flawless system, the standardization of financial statements encourages more consistency than cash-based accounting.