How Matching Concept in Accounting Ensures Accurate Reporting

matching principle

The accounting rules for depreciation and amortization stem from the matching principle. When your business purchases a long-lived asset, such as a building or a piece of equipment, that asset will help you generate revenue for years to come. To match the expense of acquiring the asset with the revenue it generates, you gradually expense the cost of the asset over its useful life. When you’re dealing with a physical asset, this process is called depreciation; when it’s an intangible asset such as a patent, it’s called amortization. Depreciation often gets described as the “effects of wear and tear” on the value of an asset. It may be helpful to think of it that way, but in reality, depreciation is strictly about cost allocation, not asset valuation. Under the matching principle, at the time your business reports revenue, it must also report the expenses directly involved in producing that revenue.

How does an income statement use the matching principle?

The matching principle is an accounting guideline which aims to match expenses with associated revenues for the period. The principle states that a company's income statement will reflect not only the revenue for the period reported but also the costs associated with those revenues.

If an ink-and-toner company buys a truckload of cartridges in June to resell to customers over the next several months, it does not record the cost of all those cartridges in June. Rather it records the cost of each cartridge on the income statement when the cartridge is sold. 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. Several examples of the matching principle are noted below, for commissions, depreciation, bonus payments, wages, and the cost of goods sold. Ow does the accountant know which expenses brought which revenues? The answer is just that the all of the reporting period’s “revenue” earnings match only with all “expenses” incurred in the same period. N the US, Canada, the UK, and in many other countries, accounting principles such as the matching concept appear in GAAP .

Matching Principle Example Calculation

The matching principle is an important accounting concept which states that revenues and expenses are recorded in the Income Statement on the same accounting period in which they occurred. Accrual accounting is based on the matching principle, which defines how and when businesses adjust the balance sheet. If there is no cause-and-effect relationship leading to future related revenue, then the expenses can be recorded immediately without adjusting entries. Investors typically want to see a smooth and normalized income statement where revenues and expenses are tied together, as opposed to being lumpy and disconnected. By matching them together, investors get a better sense of the true economics of the business.

In a complex business environment, prudent decision-makers will question that claim before trusting the ROI. Revenues earned during the period, therefore, may exist as accounts receivable, other receivables, or as cash received. Suppose a business pays a 20% commission to sales assistants by the end of every month. Match the expenses in a current period of time during which they incur rather than a time when payment is complete.

What is Matching Concept Role in ROI and Other Financial Metrics?

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. In such a case, the marketing expense would appear on the income statement during the time period the ads are shown, instead of when revenues are received.

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For twenty years, the proven standard in business, government, education, health care, non-profits. An expense for delivery vehicle fuel, for instance, uses up cash assets. The purpose of the matchingconcept is to avoid misstating earnings for a period. Employee Bonuses are based on an employee’s performance during the financial year and are paid the following year.

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Under cash basis accounting, firms claim revenues when they, in fact, receive the cash payment for them. Similarly, under cash basis accounting, they report expenses when, in fact, they pay them, in cash. As a result, the matching concept does not apply under “cash basis accounting.” The difference between cash and accrual accounting boils down to “revenue recognition,” or when your company records revenue. In cash accounting, you recognize revenue when you receive cash. So if you deliver $500 worth of merchandise to a customer and send that customer a bill, you wouldn’t record the revenue until the customer paid the invoice. In accrual accounting, you record revenue when you earn it, regardless of when the customer pays.

Suppose also the firm reports sales revenues for the quarter at $600,000. However, the firm’s customers may not, in fact, pay all they owe during the quarter. And, also suppose that the firm pays $30,000 for floorspace rent each month, for using the shop, and payment is due in advance on the first of each month. 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. Online marketing costs are recognized as costs in the income statement for the period in which the ad is displayed, not when you receive the resulting revenue.

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matching principle

When companies are profitable, they are more inclined to give out bonuses to their employees. For each year, the depreciation expense to be recorded is $20,000. Expenses not directly tied to revenue production should be expensed immediately in the current period. On the balance sheet at the end of 2018, a bonuses payable balance of $5 million will be credited, and retained earnings will be reduced by the same amount , so the balance sheet will continue to balance.

In the accrual accounting method, revenue is accounted for when it is earned. This usually will happen before money changes hands, for example when a service is delivered to a customer with the reasonable expectation that money will be paid in the future. The matching principle is used in financial accounting to ensure that revenues and expenses are correctly matched in the period they occur. This helps to provide an accurate view of the company’s financial position and performance. Overall, expenses can be broken into two major categories – product and period costs.

  • It should be mentioned though that it’s important to look at the cash flow statement in conjunction with the income statement.
  • 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.
  • For the month of November, the company earned $100,000 in sales, and they will pay their sales reps $10,000 in resulting commission fees in December.
  • Regulatory guidelines also connect revenue and expense recognition when referring to the matching principle.
  • In the accrual basis of accounting, this is done by recording the transactions as they occur even when the actual cash from the revenue is not yet received or expenses are incurred but cash is not paid yet.
  • 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.

The firm reports earning $600,000 in revenues for the quarter just finished, even though some of this is still “payable.” The materiality conceptThis idea is the principle in financial reporting that companies disregard matters are and disclose all essential data.

By |2022-09-29T00:19:12+05:30May 21st, 2021|Bookkeeping|Comments Off on How Matching Concept in Accounting Ensures Accurate Reporting

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