Matching Principle

What is the Matching Principle?

The matching principle is an accounting guideline that 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.

This principle is based on the accrual method of accounting. We want to match the period for when the costs were incurred in the relevant period. For the matching principle, we relate this to the period when a product or service is recognized as being sold (revenue recognition).

This method is useful as it provides an accurate picture of the costs associated with revenue (or products/services delivered) over a specific period. The alternative to the accrual method is cash-based accounting, which records transactions when the money actually changes hands.

Applying the Matching Principle

Let’s look at an example of the matching principle. Take a company where materials are bought with cash in Year 1. They are sold on credit and delivered to the customer in Year 2. Cash from the customer is received in Year 3. What we need to work out is which period the transactions will be recognized in each of the financial statements.

Applying this to the Income Statement

The income statement has two line items that are going to be affected:

• Revenue
• Cost of Goods Sold (COGS)

If we start with year 1, we can see that the materials were purchased with cash. However, the product was not sold until year 2. The products were delivered to the customer in year 2 so revenue can be recognized during this period.

The COGS must be matched with the associated revenues. Therefore, both the revenue and cost of goods sold will be recorded at the time of delivery, in year 2.

Applying this to the Balance Sheet

Inventory is a line item on the balance sheet and is affected by this transaction. Inventory is purchased in the form of materials in year 1. Therefore, the company will report an increase in inventory in year 1. In year 2, this inventory is then sold, resulting in a decrease in the reported inventory balance.

Applying this to the Cash Flow Statement

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 sold on credit, so no cash is received. It can be recognized as revenue on the income statement as this is the period when the product was delivered to the customer. However, it cannot be reported in the cash flow statement as no cash has been received. A positive cash flow cannot be reported until year 3 on the company’s financial statements.

As we can see in this example, two transactions have been spread across a total of three years. This illustrates 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.

What Are the Benefits of Matching Principle?

The benefits of the matching principle include:

• Accurate Financial Reporting: by matching expenses with the revenues they generate, the financial statements provide a more accurate representation of a company’s financial performance
• Consistency: it ensures consistency in financial reporting, making it easier to compare financial statements across different periods
• Better Decision Making: accurate financial statements enable better decision-making by management, investors, and other stakeholders
• Compliance with Accounting Standards: The matching principle is a fundamental concept in accrual accounting, which is required by many accounting standards

What Are the Challenges of Matching Principle?

The challenges of implementing the matching principle include:

• Complexity: determining the correct period to match expenses with revenues can be complex, especially when dealing with long-term projects or contracts
• Estimation: sometimes, it requires estimation of future costs and revenues, which can introduce inaccuracies
• Timing Issues: there can be timing issues when expenses are incurred in one period, but the related revenues are recognized in another period
• Inventory Management: for retailers, managing inventory and ensuring that the cost of goods sold is matched with the correct sales period can be challenging

Example of the Matching Principle

Let’s look at an example of the matching principle: we are told that:

1. Materials were bought in Year 1
2. They were sold on credit and delivered to the customer in Year 2
3. Cash from the customer is received in Year 3

Download the free Financial Edge template to go with this example.

The first stage is to assign the sales to the period in which they took place – this can often be tricky when the payment isn’t made at the time the goods were exchanged. The best way to determine this is to look at when the goods or services were delivered to the customer. In this example, it is Year 2, so we can select Year 2 as the period where revenue will appear on the income statement. As a result, the COGS associated with those sales will also be assigned to Year 2.

The balance sheet will look at things from a different perspective. The inventory was purchased in Year 1 so this will be recorded as an increase in inventory on the balance sheet in Year 1. When the product is sold in Year 2, this will reduce the inventory which also needs to be reflected on the balance sheet.

In terms of the cash flow, cash is used to purchase the inventory in Year 1 so will be recorded as a cash outflow in the period. No cash is received in Year 2 as the product was sold on credit, so a cash inflow will not be recorded until Year 3 when the payment is settled.

Importance of the Matching Principle

The matching principle is crucial because it ensures that sales and the associated costs are recorded in the same period. This principle helps in accurately reflecting the financial performance of a company. For example, if sales occurred in the year 2000, the costs related to those sales, even if the inventory was purchased in 1999, should be recorded in the 2000 income statement. This alignment provides a clear and accurate picture of the company’s profitability during a specific period.

Conclusion

The matching principle is essential for accurate financial reporting as it ensures that expenses are recorded in the same period as the revenues they generate. This principle not only provides a clear picture of a company’s profitability but also enhances consistency and compliance with accounting standards.