Matching Accounting Principles

[Meghan Beas]

Matching principle is an accounting principle for recording revenues and expenses. It requires that a business records expenses alongside revenues earned. Ideally, they both fall within the same period of time for the clearest tracking. This principle recognizes that businesses must incur expenses to earn revenues.

Matching principle is especially important in the concept of accrual accounting. Matching principle states that business should match related revenues and expenses in the same period. They do this in order to link the costs of an asset or revenue to its benefits.

The expense must relate to the period in which the expense occurs rather than on the period of actually paying invoices. For example, if a business pays a 10% commission to sales representatives at the end of each month. If the company has $50,000 in sales in the month of December, the company will pay the commission of $5,000 next January.

Some businesses follow the matching principle. These businesses report commission expenses on the December income statement. Other companies use a cash basis of accounting. In this case, they report the commission in January because it is the payment month. The alternative is reporting the expense in December, when they incurred the expense.

Recognizing expenses at the wrong time may distort the financial statements greatly. A business may end up with an inaccurate financial position of its finances. The matching principle helps businesses avoid misstating profits for a period.

Certain financial elements of business also benefit from the use of the matching principle. Long-term assets experience depreciation. The matching principle allows distributing an asset and matching it over the course of its useful life in order to balance the cost over a period.

This principle is an effective tool when expenses and revenues are clear. However, sometimes expenses apply to several areas of revenue, or vice versa. Account teams have to make estimates when there is not a clear correlation between expenses and revenues. For example, you may purchase office supplies like pens, notebooks, and printer ink for your team. These items are necessary, but may not correlate to revenue.

For example, a business spends $20 million on a new location with the expectation that it lasts for 10 years. The business then disperses the $20 million in expenses over the ten-year period. If there is a loan, the expense may include any fees and interest charges as part of the loan term. This disbursement continues even if the business spends the entire $20 million upfront.

Understanding the matching principle is crucial for producing accurate financial reports, but manual implementation can be time-consuming, error-prone, and complex. According to Gartner, 86% of finance executives aim to achieve a faster, real-time close by 2025, with more than half of respondents already investing in general ledger technology and workflow automation. Moreover, 70% of companies that have automated more than one-fourth of their accounting functions report moderate or substantial ROI.

For example, if a company named RadiusKarzz purchases machinery for $100,000 with a useful life of 10 years, it can allocate an annual depreciation expense of $10,000. This ensures that the financial statements reflect the gradual wear and tear of the machinery accurately.

For example, if a company mistakenly recognizes $10,000 in expenses in the current period when they belong to the next period, it would lower the net income for the current period. Conversely, delaying the recognition of $10,000 in expenses to the next period would inflate the net income for the current period. The matching principle prevents such misstatements of profits.

Determine the expenses that are directly associated with generating those revenues. These expenses may include the cost of goods sold, salaries of employees involved in the sales production, rent, utilities, and other operating expenses.

Prepare financial statements, including the income statement, after adjusting entries to show net income or loss. Analyze them by comparing them with previous periods or industry benchmarks to assess performance and profitability.

One of the ways to implement the matching concept in accounting is to do a journal entry. Journal entries are formal records of financial transactions that help implement the matching principle by ensuring revenues are recognized when earned, and expenses are matched in the same period, aligning with accrual accounting. Moreover, journal entries help accurately document and reflect the matching of revenues and expenses, contributing to accurate financial statements.

Increasing complexity of revenue recognition: Revenue recognition is complex due to factors such as project completion timing and revenue allocation for different product parts. Establishing a direct cause-and-effect relationship between revenue and expenses is also challenging, as business operations, multiple revenue streams, and external factors can influence revenue generation and expense levels. Contract changes can further complicate expense tracking and allocation, requiring careful management. Revenue recognition is challenging due to various factors. Firstly, if a project takes a long time to complete, it can be tricky to determine when to recognize the revenue earned from that project.

For example, revenue recognition complexity for a software company named Radius Cloud stems from bundled offerings, such as combining software licenses with ongoing maintenance and support services. Determining the appropriate revenue allocation between the initial license sale and recurring services becomes challenging. Similarly, revenue derived from additional services like customization or consulting is intertwined with software license revenue, making it difficult to establish a direct cause-and-effect relationship between revenue and expenses.

Challenges in matching revenues with expenses for marketing campaigns: When running a marketing campaign, a company incurs upfront expenses for advertising, promotions, and creative development. However, the revenue generated from the campaign may be realized over an extended period as customers gradually respond to the marketing efforts and make purchases. This delay makes it difficult to accurately align the timing of expenses with the corresponding revenue.

For instance, a company named Radius Cloud runs a one-month advertising campaign with upfront expenses, but the resulting revenue from increased product sales is realized over several months as customers respond to the campaign. The mismatch in timing makes the implementation of the matching principle difficult.

Uncertainty and timing differences: Uncertainty arises when the outcome of a transaction is uncertain, such as in cases of potential legal disputes or contingent liabilities. Timing differences occur when the recognition of revenue or expenses is spread over multiple accounting periods due to factors like long-term contracts or installment payments. Uncertainty makes it difficult to predict transaction outcomes, while timing differences can lead to discrepancies between cash flows and their recognition in financial statements.

For instance, Radius Cloud receives stock as payment, making revenue recognition tricky. Valuing the stock is complicated by its fluctuating value, requiring judgment and estimation. The stock may need to be held for a certain period before its value can be realized.

The accrual principle recognizes revenues and expenses in the period they are earned/incurred, while the matching principle requires expenses to be recognized in the same period as related revenues. The former focuses on timing, while the latter links expenses to revenues.

The revenue recognition principle requires revenue to be recognized when it is earned, not when payment is received. This principle ensures accurate financial reporting by requiring revenue to be recorded in the accounting period in which it is earned.

The matching principle requires expenses to be recognized in the period in which the related revenues are earned. Accrued expenses are recognized when incurred, regardless of payment timing. This ensures expenses are matched with revenues generated, providing accurate financial reporting.

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