The matching principle requires that expenses should be matched to revenues earned during an accounting period. Matching principle is especially important in the concept of accrual accounting. Matching principle states that business should match related revenues and expenses in the same period.
Balance Sheet
For example, it may not make sense to create a journal entry that spreads the recognition of a $100 supplier invoice over three months, even if the underlying effect will impact all three months. Doing so makes better use of the accountant’s time, and has no material impact on the financial statements. Obviously, the general manager’s salary and those of other administrative staff cannot be related to a specific product. Accordingly, they are charged as expenses in the income statement of the accounting period in which the salaries are paid. Consequently, the first step must be to determine the revenues earned during a particular accounting period and then to identify the expenses incurred, thereby determining the revenues earned during that accounting period.
- 11 Financial may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements.
- A business may end up with an inaccurate financial position of its finances.
- It may not be able to track the timing of the revenue that comes in, as customers may take months or years to make a purchase.
It should be mentioned though that it’s important to look at the cash flow statement in conjunction with the income statement. 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. In February 2019, when the bonus is paid out there is no impact on the income statement.
Matching principle
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 matching principle also states that expenses should be recognized in a “rational and systematic” manner. This is the key concept behind depreciation where an asset’s cost is recognized over many periods. The matching principle, then, requires that expenses should be matched to the revenues of the appropriate accounting period and not the other way around.
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The matching principle requires that revenues and any related expenses be recognized together in the same reporting period. Thus, if there is a cause-and-effect relationship between revenue and certain expenses, then record them at the same time. In some cases, it will be necessary to conduct a systematic allocation of a cost across multiple reporting periods, such as when the purchase cost of a fixed asset is depreciated over what is creditors turnover ratio several years. If there is no cause-and-effect relationship, then charge the cost to expense at once.
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. 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 accounting and bookkeeping hawaii 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.
Disadvantages of the Matching Principle
If a future benefit is not expected then the matching principle requires that the cost is treated immediately as an expense in the period in which it was incurred. The asset has a useful life of 5 years and a salvage value at the end of that time of 4,000. The business uses the straight line depreciation method and calculates the annual depreciation expense as follows. Note that although the sales commission is not paid until April, based on the matching principle, the sales commission is an expense for the month of March as it has been matched to revenue recognized in that month.
The cash balance declines as a result of paying the commission, which also eliminates the liability. Under a bonus plan, an employee earns a $50,000 bonus based on measurable aspects of her performance within a year. You should record the bonus expense within the year when the employee earned it. Finance Strategists has an advertising relationship with some of the companies included on this website.
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It should charge the cost of the equipment to depreciation expense at the rate of $10,000 per year for ten years, so that the expense is recognized over the entirety of its useful life. 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. 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.
Since there is an expected future benefit from the use of the asset the matching principle requires that the cost of the asset is spread over its useful life. As there is no direct link between the expense and the revenue a systematic approach is used, which in this case means adopting an appropriate depreciation method such as straight line depreciation. The matching principle states that expenses should be recognized and recorded when those expenses can be matched with the revenues those expenses helped to generate.
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.
Thus, the machine is depreciated over its 10-year useful life instead of being fully expensed in 2015. This concept applies to all kinds of business transactions involving assets, liabilities and equity, revenue and expense recognition. Otherwise, the title should have been passed onto the buyer so as to create a legal obligation for the buyer to pay for them.
