The matching principle is an accounting guideline which helps match items, such as sales and costs related to sales for the same periods. 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. This principle is based on the accrual method of accounting. Reporting revenues and costs this way means a liability or asset may occur which is not related to that reporting period.
We want to match the period for when the costs have incurred to the relevant period. For the matching principle, we relate this to the period for when a product or service is recognized as being sold (revenue recognition).
Let’s assume company X purchases some materials using cash in year 1. The company decides to use those materials to manufacture a product and then goes on to sell this new product in year 2 to customers on credit. Cash is then received from the customers in year 3.
How will the different transactions look on the companies financial statements?
Let’s first start with the income statement. The income statement has two line items which are going to be affected, revenue and cost of goods sold. If we start with year 1, we can see that company X purchased materials with cash. However, the product was not actually sold until the accounting period in year 2. The matching principle says we want to match the periods for expenses when the product is sold. This will mean that both revenue and cost of goods sold for the items purchased and sold will go into year 2’s income statement.
Next is the balance sheet and we want to ask the same question of what items in this report are going to be affected. We can see that we have purchased some inventory in the form of materials in year 1. Therefore, company X will report an increase of their inventory in year 1. In year 2, this inventory was then sold. Now the inventory figure can be reduced from the product being sold.
Cash Flow Statement
Lastly is the cash flow statement and, again, we want to ask what items in this statement will be affected by the transactions. Well, the materials were purchased using cash in year 1. This will result in a decrease in the cash account and, therefore, a negative cash flow. Even though the product was sold in year 2, it was only sold on credit. This means it can be recognized as revenue on the income statement (the product was delivered to the customer), but can’t be reported on the cash flow statement as no cash has been received. This means a positive cash flow cannot be reported until year 3 on the companies financial statements.
As we can see in this example, two transactions have been spread across a total of three years. This example is designed to illustrate the importance of the matching principle as, even though the materials were purchased in year 1, they weren’t sold until year 2. If expenses were reported as soon as they occurred, then company statements would be very inconsistent and profit figures would not be comparable.