In order to reach accurate net income figure, the expenses incurred to earn the revenues recognized during the accounting period should be recognized in that time period and not in the next or previous. This is called matching principle of accounting.
- $2,000,000 worth of sales are made in 2010. Total purchases of inventory were $1,000,000 of which $100,000 remained on hand at the end of 2010. The cost of earnings is $2,000,000 revenue is $900,000 [$1,000,000 minus $100,000] and this should be recognized in 2010 thereby yielding a gross profit of $1,100,000.
- A hospital pays $20,000 per month to 5 of its doctors. Monthly sales are $500,000. $100,000 worth of monthly salaries should be matched with $500,000 of revenue generated.
Matching principle is relevant to the time period assumption, the revenue recognition principle and it is at the heart of accrual basis of accounting.
Written by Obaidullah Jan, ACA, CFA