Because revenue recognition and the cost of goods sold are so closely related, the corporation should recognize the entire $4,000 cost as an expense in the same reporting period as the sale. Product costs refer to the expenses incurred during the product’s manufacturing. The accrual or matching principle states that we should simultaneously calculate the cost of producing a commodity as we calculate the income from sold commodities. 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.
Revenues and expenses are matched on the income statement for a period of time (e.g., a year, quarter, or month). ＄4,000 of the estimated current tax charge relates to prepaid income, recognised in the subsequent accounting period. Consequently, ＄4,000 must be subtracted from the tax expense calculation and matched against the accounting profit earned in the next year.
The realization and accrual concepts are essentially derived from the need to match expenses with revenues earned during an accounting period. It takes more effort from the accountant to record accruals to transfer expenses across reporting periods. Because it is relatively sophisticated, small firms without accountants may find it challenging to use.
Importance of Matching Concept
Doing so is moderately complex, making it difficult for smaller businesses without accountants to use. For example, it can be difficult to determine the impact of ongoing marketing expenditures on sales, so it is customary to charge marketing expenditures how to calculate profit margin for small business owners to expense as incurred. 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 is used up.
The disbursement will be done across the ten years even though the business already spent the entire ₹10,00,00,000 upfront. Otherwise, the title should have been passed onto the buyer so as to create a legal obligation for the buyer to pay for them. The second aspect is that the full cost of those items must be included in that particular period’s income statement. First, that the revenue has been earned in the period in which it is included in the income statement. Using an accrual entry to record items using the principle is typical. The following is an example of a commission payment entry; this will make you understand it better.
- Similarly, if a fee is earned for providing a service, the first test is to ensure that the service in question has been duly provided.
- It also stipulates that a current liability of $6,000 be included on the December 31 balance sheet.
- The matching principle links expenses to the related revenues, while the revenue recognition principle requires revenue to be recognized when it’s earned.
- The matching concept is aligned with adjusting entries and the accrual basis of accounting.
It shares characteristics with accrued revenue (or accrued assets) with the difference that an asset to be covered latter are proceeds from a delivery of goods or services, at which such income item is earned. 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.
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 (lower net income), so the balance sheet will continue to balance. In 2018, the company generated revenues of $100 million and thus will pay its employees a bonus of $5 million in February 2019. A company should use the same method to account for inventory from period to period. This will make it easier to compare the company’s financial performance from one period to the next. The conservatism principle states that the company should choose the accounting treatment that is most likely to result in an overstatement of bad debts.
The matching principle concept is extremely beneficial when it comes to reporting revenues and expenses. An expense needs to relate to the time period that it occurred and not during the actual payment of the invoices. Assume that a business gives out commissions to its representatives at 10% of their sales, disbursed at the end of the month. If the business makes sales of ₹40,00,000 in January 2022, it will need to pay ₹400,000 in commission in February 2022.
Some other specific examples of the matching principle
If the company has $50,000 in sales in the month of December, the company will pay the commission of $5,000 next January. While accrual accounting is not a flawless system, the standardization of financial statements encourages more consistency than cash-based accounting. 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. For example, if the office costs $10 million and is expected to last 10 years, the company would allocate $1 million of straight-line depreciation expense per year for 10 years.
Important Concepts in Accounting
It provides businesses with a means of recognising this idea while keeping their accounting records. This principle has its basis in the cause and effect relationship that exists between revenue and expenses. It needs a business to record all its business expenses in the same period as the revenues related to it. Matching principle is an important concept of accrual accounting which states that the revenues and related expenses must be matched in the same period to which they relate. Additionally, the expenses must relate to the period in which they have been incurred and not to the period in which the payment for them is made.
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 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.
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Team members will receive a $1,000 bonus next year on March 15th, 2023. Since the expense is only indirectly related to revenue, the matching principle requires that the company records the bonus expense before the new year. Businesses primarily follow the matching principle to ensure consistency in financial statements. The principle is at the core of the accrual basis of accounting and adjusting entries.
Understanding the Matching Principle in Accounting
In this article, we will dive deep into the 15 core accounting concepts in more detail, understand Accounting Concepts vs. Convention, and explore the importance of these concepts. There are many different accounting concepts and they are constantly evolving, as new accounting standards are developed and adopted. Consider that a business incurs the cost of ₹10,00,00,000 on buying an office space expecting that it will serve the business for a period of ten years. In case a loan has been taken for the purchase, then the expense could also include all fees and the interest that is charged on loan for the term it was taken.
If an item isn’t directly related to revenue, it should be mentioned in the income statement in the prevailing accounting period in which it expires or is depleted. 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. Matching principle therefore results in the presentation of a more balanced and consistent view of the financial performance of an organization than would result from the use of cash basis of accounting. 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. With the help of adjusting entries, accrual accounting and the matching principle let you know what money is available for use and helps keep track of expenses and revenue.
The matching concept is crucial for organizations to disclose their financial results properly. 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 matching principle stabilizes the financial performance of companies to prevent sudden increases (or decreases) in profitability which can often be misleading without understanding the full context. In contrast, cash-basis accounting would record the expense once the cash changes hands between the parties involved in the transaction. Thank you for reading this guide to understanding the accounting concept of the matching principle.