What is 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. 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 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).
Key Learning Points
- The income statement is built on the accruals concept which means sales and expenses are recognized in the period in which they are generated
- Revenue recognition is an accounting principle which looks at when revenue can be recognized in an accounting period (typically when the revenues is earned and when the product or service has been delivered)
- Expenses are matched with revenues for the period using the accruals concept
Applying the Matching Principle
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. In which period will the transactions be recognized in each of the financial statements?
The income statement has two line items which are going to be affected, revenue and 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.
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.
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. This means it can be recognized as revenue on the income statement (the product was delivered to the customer), but can not 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 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.