What Is the Matching Principle and Why Is It Important?

A common example of the matching principle in use is recording the related expense and revenue on grants. IU receives a grant to assist international students with adjusting to life in the United States and at IU. https://www.bookstime.com/ The grant is received in May of 20XX, but students do not arrive until August 20XX. IU staff purchases tickets to the Indiana University Cinema to take students to a movie their first week on campus in August.

• Objectivity Principle – financial statements, accounting records, and financial information as a whole should be independent and free from bias.
• The financial statements are meant to convey the financial position of the company and not to persuade end users to take certain actions.
• The revenue recognition principle, a feature of accrual accounting, requires that revenues are recognized on the income statement in the period when realized and earned—not necessarily when cash is received.
• Smaller enterprises may choose to use cash accounting as their accounts are not used externally or by third parties.
• You will be able to reference these principles and reason your way through revenue, expense, and any other combination of problems later on in the study course.
• This assumes that a company will continue to exist long enough to carry out its objectives and commitments and will not liquidate in the foreseeable future.

So, the expense and the revenue will be booked in September, when the revenue was generated. Using the matching principle, costs are also properly accounted for, resulting in more accurate financial statements. 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. Several examples of the matching principle are noted below, for commissions, depreciation, bonus payments, wages, and the cost of goods sold.

What are the benefits of the matching principle?

All of these are situations where general principles from the conceptual framework seem to be in conflict and judgment needs to be applied to determine what application will provide the most relevant information to investors. A company usually lists its significant accounting policies as the first note to its financial statements. Revenue Recognition
Revenue Recognition is the accounting principle defining what earned revenue is, when to recognize or account for that revenue, and how much of it is measurable. Depreciation allows a company to recognize that this purchase is an expense; the asset will wear up over its useful life and will need to be replaced.

• 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.
• The amount reported should include all costs necessary to acquire the asset and prepare it for use including delivery and handling costs, site preparation fees, and installation costs.
• There are situations in which using the matching principle can be a disadvantage.
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The matching principle is one of the ten accounting principles included in Generally Accepted Accounting Principles (GAAP), stating that businesses are required to match income to related expenses in a specific period of time. 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. Per the matching principle, expenses are recognized once the income resulting from the expenses is recognized and “earned” under accrual accounting standards. Businesses primarily follow the matching principle to ensure consistency in financial statements.

Example of Matching Principle

Depreciation is used to distribute the cost of the asset over its expected life span according to the matching principle. 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. Because the items generated revenue, the local shop will match the cost of $1,000 with the $6,000 of revenue at the end of the accounting period.

However, the matching principle matches expenses with the revenue they helped generate, as opposed to being recorded in the period the actual cash outflow was incurred. 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 https://www.bookstime.com/articles/matching-principle 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. By contrast, if the company used the cash basis of accounting rather than accrual, they would record the revenue in November and the commission in December.

Periodicity Assumption

Thank you for reading this guide to understanding the accounting concept of the matching principle. 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. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. Now, if we apply the matching principle discussed earlier to this scenario, the expense must be matched with the revenue generated by the PP&E. PP&E, unlike current assets such as inventory, has a useful life assumption greater than one year.

• A bonus that was earned by employees in 2020 is recorded in 2020 to match the expense to the time of the employee effort rather than in 2021 when it is objectively paid.
• Not all costs and expenses have a cause and effect relationship with revenues.
• This isn’t just memorizing some accounting information for a test and then forgetting it two days later.
• Assets are recorded at cost, which equals the value exchanged at the time of their acquisition.

Depreciation expense reduces income for each period that the expense is recorded. The pay period for hourly employees ends on March 28, but employees continue to earn wages through March 31, which are paid to them on April 4. The employer should record an expense in March for those wages earned from March 29 to March 31. In contrast, cash-basis accounting would record the expense once the cash changes hands between the parties involved in the transaction. On a larger scale, you may consider purchasing a new building for your business. There’s no way to tell if a larger space or better location improves revenue.

What Is Accounting Standards Codification (ASC) 606?

The old guidance was industry-specific, which created a system of fragmented policies. The updated revenue recognition standard is industry-neutral and, therefore, more transparent. It allows for improved comparability of financial statements with standardized revenue recognition practices across multiple industries. On May 28, 2014, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) jointly issued Accounting Standards Codification (ASC) 606, regarding revenue from contracts with customers. Analysts, therefore, prefer that the revenue recognition policies for one company are also standard for the entire industry.

This is so important because transactions that affect the separate owners of a business and not the business itself will be left out of our accounting for the business. Two businesses that may be closely related may need to be accounted for separately because they have different ownership. Other businesses may be combined for financial reporting because they have the same ownership – it depends on the business entity assumption that is being made. Accounting principles are determined by private sectors which means they are not mandated and have no authoritative requirement, but are instead generally accepted (i.e., Generally Accepted Accounting Principles – GAAP). However, because most accountants were taught these accounting principles in formal education, most companies follow GAAP as though they are the law. The purpose of GAAP is to ensure that financial statements of U.S businesses (and perhaps worldwide one day) are consistent and comparable.