Matching principle is one of the most fundamental principles in accounting. It requires that a company must record expenses in the period in which the related revenues are earned. Matching concept is at the heart of accrual basis of accounting.
It is important to match expenses with revenues because net income, i.e. the net amount earned in a period, is calculated by subtracting expenses from revenues. If expenses are not properly recorded in the correct period, the net income for a particular period may be either understated or overstated and so are the related balance sheet balances.
Matching principle is what differentiates the accrual basis of accounting from cash basis of accounting. It requires recognition of revenues and expenses regardless of the actual receipt of cash from revenues and actual payment of cash for expenses.
In order to apply the matching principle, management of a company is required to apply judgment to estimate the timing and amount of revenues and expenses. Prudence concept, which is a related accounting principle, requires companies not to overstate revenues, understate expenses, overstate assets and/or understate liabilities.
In line with the materiality concept, a company is not required to trace every dollar of expense to every dollar of revenue because the cost of doing so would exceed the potential benefit.
Example 1: When a company makes sales, majority of it are against credit, i.e. where the customer receives delivery of goods or services but promises to make the payment, say within 30 days. In accordance with revenue recognition principle, revenue is recognized when the delivery is made. Now, there is a risk that the customers may not pay the amount due against those sales, which results in the company writing off the account receivable as bad debts expense. The possibility of bad debts exists when the sale is made, so expense should be recognized right at that moment when the sale is made. Recognizing bad debts expense requires considerable estimation.
Example 2: Company B generates $2,000,000 in revenue in 2010. Total purchases of inventories were $1,000,000 of which $100,000 remained on hand at the end of 2010. The cost of sales should be reflected in the income statement at $900,000 [$1,000,000 minus $100,000]. The company’s gross profit for 2010 should be $1,100,000 (=$2,000,000 minus $900,000). The main point is to subtract only that much expense in a particular period which is related to the revenues earned in that period. Since $100,000 worth of inventories are to be sold in next period, they should not be subtracted from revenue for the current period.
Example 3: 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.
Written by Obaidullah Jan, ACA, CFA