Matching principle
Encyclopedia
The matching principle is a culmination of accrual accounting and the revenue recognition
principle. They both determine the accounting period
, in which revenues and expenses are recognized. According to the principle, expenses are recognized when obligations are (1) incurred (usually when goods are transferred or services rendered, e.g. sold), and (2) offset against recognized revenues, which were generated from those expenses (related on the cause-and-effect basis), no matter when cash is paid out. In cash accounting—in contrast—expenses are recognized when cash is paid out, no matter when obligations are incurred through transfer of goods or rendition of services: e.g., sale.
If no cause-and-effect relationship exists (e.g., a sale is impossible), costs are recognized as expenses in the accounting period
they expired: i.e., when have been used up or consumed (e.g., of spoiled, dated, or substandard goods, or not demanded services). Prepaid expenses are not recognized as expenses, but as assets until one of the qualifying conditions is met resulting in a recognition as expenses. Lastly, if no connection with revenues can be established, costs are recognized immediately as expenses (e.g., general administrative and research and development costs).
Prepaid expenses, such as employee wages or subcontractor fees paid out or promised, are not recognized as expenses (cost of goods sold
), but as assets (deferred expenses), until the actual products are sold.
The matching principle allows better evaluation of actual profitability and performance (shows how much was spent to earn revenue), and reduces noise from timing mismatch between when costs are incurred and when revenue is realized.
s as expenses are recognized, because expenses are recognized when obligations are incurred regardless when cash is paid out according to the matching principle in accrual accounting. Cash can be paid out in an earlier or latter period than obligations are incurred (when goods or services are received) and related expenses are recognized that results in the following two types of accounts:
Accrued expenses is a liability with an uncertain timing or amount, but where the uncertainty is not significant enough to qualify it as a provision
. An example is an obligation to pay for goods or services received from a counterpart, while cash for them is to be paid out in a later accounting period
when its amount is deducted from accrued expenses. It shares characteristics with deferred income
(or deferred revenue) with the difference that a liability to be covered latter is cash received from a counterpart, while goods or services are to be delivered in a latter period, when such income item is earned, the related revenue
item is recognized, and the same amount is deducted from deferred revenues.
Deferred expenses (or prepaid expenses or prepayment) is an asset
, such as cash paid out TO a counterpart for goods or services to be received in a latter accounting period
when fulfilling the promise to pay is actually acknowledged, the related expense
item is recognized, and the same amount is deducted from prepayments. It shares characteristics with accrued revenue (or accrued assets) with the difference that an asset to be covered latter are proceeds from a delivery of goods or services, at which such income item is earned and the related revenue
item is recognized, while cash for them is to be received in a later period, when its amount is deducted from accrued revenues.
For example, supplying goods in one accounting period
by a vendor, but paying for them in a later period results in an accrued expense that prevents a fictitious increase in the receiving company's value equal to the increase in its inventory
(assets) by the cost of the goods received, but unpaid. Without such accrued expense, a sale of such goods in the period they were supplied would cause that the unpaid inventory (recognized as an expense
fictitiously incurred) would effectively offset the sale proceeds (revenue
) resulting in a fictitious profit in the period of sale, and in a fictitious loss in the latter period of payment, both equal to the cost of goods sold.
Period costs, such as office salaries or selling expenses, are immediately recognized as expenses (and offset against revenues of the accounting period
) also when employees are paid in the next period. Unpaid period costs are accrued expenses (liabilities) to avoid such costs (as expenses fictitiously incurred) to offset period revenues that would result in a fictitious profit. An example is a commission earned at the moment of sale (or delivery) by a sales representative who is compensated at the end of the following week, in the next accounting period. The company recognizes the commission as an expense
incurred immediately in its current income statement
to match the sale proceeds (revenue), so the commission is also added to accrued expenses in the sale period to prevent it from otherwise becoming a fictitious profit, and it is deducted from accrued expenses in the next period to prevent it from otherwise becoming a fictitious loss, when the rep is compensated.
used to enable management of costs paid out and not recognized as expenses according to the matching principle.
For example, when the accounting period
s are monthly, an 11/12 portion of an annually paid insurance
cost is added to prepaid expenses, which are decreased by 1/12 of the cost in each subsequent period when the same fraction is recognized as an expense
, rather than all in the month in which such cost is billed. The not-yet-recognized portion of such costs remains as prepayments (assets) to prevent such cost from turning into a fictitious loss in the monthly period it is billed, and into a fictitious profit in any other monthly period.
Similarly, cash paid out for (the cost of) goods and services not received by the end of the accounting period
is added to the prepayments to prevent it from turning into a fictitious loss in the period cash was paid out, and into a fictitious profit in the period of their reception. Such cost is not recognized in the income statement
(profit and loss or P&L) as the expense
incurred in the period of payment, but in the period of their reception when such costs are recognized as expenses in P&L and deducted from prepayments (assets) on balance sheets.
is used to distribute the cost of the asset over its expected life span according to the matching principle. If a machine is bought for $100,000, has a life span of 10 years, and can produce the same amount of goods each year, then $10,000 of the cost of the machine is matched to each year, rather than charging $100,000 in the first year and nothing in the next 9 years. So, the cost of the machine is offset against the sales in that year. This matches costs to sales.
Revenue recognition
The revenue recognition principle is a cornerstone of accrual accounting together with matching principle. They both determine the accounting period, in which revenues and expenses are recognized...
principle. They both determine the accounting period
Accounting period
An accounting period is a period with reference to which United Kingdom corporation tax is charged. It helps dictate when tax is paid on income and gains...
, in which revenues and expenses are recognized. According to the principle, expenses are recognized when obligations are (1) incurred (usually when goods are transferred or services rendered, e.g. sold), and (2) offset against recognized revenues, which were generated from those expenses (related on the cause-and-effect basis), no matter when cash is paid out. In cash accounting—in contrast—expenses are recognized when cash is paid out, no matter when obligations are incurred through transfer of goods or rendition of services: e.g., sale.
If no cause-and-effect relationship exists (e.g., a sale is impossible), costs are recognized as expenses in the accounting period
Accounting period
An accounting period is a period with reference to which United Kingdom corporation tax is charged. It helps dictate when tax is paid on income and gains...
they expired: i.e., when have been used up or consumed (e.g., of spoiled, dated, or substandard goods, or not demanded services). Prepaid expenses are not recognized as expenses, but as assets until one of the qualifying conditions is met resulting in a recognition as expenses. Lastly, if no connection with revenues can be established, costs are recognized immediately as expenses (e.g., general administrative and research and development costs).
Prepaid expenses, such as employee wages or subcontractor fees paid out or promised, are not recognized as expenses (cost of goods sold
Cost of goods sold
Cost of goods sold refers to the inventory costs of those goods a business has sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out , or average cost...
), but as assets (deferred expenses), until the actual products are sold.
The matching principle allows better evaluation of actual profitability and performance (shows how much was spent to earn revenue), and reduces noise from timing mismatch between when costs are incurred and when revenue is realized.
Expense vs. cash timing
Two types of balancing accounts exist to avoid fictitious profits and losses that might otherwise occur when cash is paid out not in the same accounting periodAccounting period
An accounting period is a period with reference to which United Kingdom corporation tax is charged. It helps dictate when tax is paid on income and gains...
s as expenses are recognized, because expenses are recognized when obligations are incurred regardless when cash is paid out according to the matching principle in accrual accounting. Cash can be paid out in an earlier or latter period than obligations are incurred (when goods or services are received) and related expenses are recognized that results in the following two types of accounts:
- Accrued expense: Expense is recognized before cash is paid out.
- Deferred expense: Expense is recognized after cash is paid out.
Accrued expenses is a liability with an uncertain timing or amount, but where the uncertainty is not significant enough to qualify it as a provision
Provision (accounting)
In financial accounting, provision is a word that creates an ambiguous account title. In U.S. GAAP, provision means an expense, while in IFRS, International Financial Reporting Standards, it means a liability. So, in the U.S., Provision for Income Taxes means the same thing as Income Tax Expense,...
. An example is an obligation to pay for goods or services received from a counterpart, while cash for them is to be paid out in a later accounting period
Accounting period
An accounting period is a period with reference to which United Kingdom corporation tax is charged. It helps dictate when tax is paid on income and gains...
when its amount is deducted from accrued expenses. It shares characteristics with deferred income
Deferred income
Deferred income is, in accrual accounting, money received for goods or services which have not yet been delivered...
(or deferred revenue) with the difference that a liability to be covered latter is cash received from a counterpart, while goods or services are to be delivered in a latter period, when such income item is earned, the related revenue
Revenue
In business, revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. In many countries, such as the United Kingdom, revenue is referred to as turnover....
item is recognized, and the same amount is deducted from deferred revenues.
Deferred expenses (or prepaid expenses or prepayment) is an asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
, such as cash paid out TO a counterpart for goods or services to be received in a latter accounting period
Accounting period
An accounting period is a period with reference to which United Kingdom corporation tax is charged. It helps dictate when tax is paid on income and gains...
when fulfilling the promise to pay is actually acknowledged, the related expense
Expense
In common usage, an expense or expenditure is an outflow of money to another person or group to pay for an item or service, or for a category of costs. For a tenant, rent is an expense. For students or parents, tuition is an expense. Buying food, clothing, furniture or an automobile is often...
item is recognized, and the same amount is deducted from prepayments. It shares characteristics with accrued revenue (or accrued assets) with the difference that an asset to be covered latter are proceeds from a delivery of goods or services, at which such income item is earned and the related revenue
Revenue
In business, revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. In many countries, such as the United Kingdom, revenue is referred to as turnover....
item is recognized, while cash for them is to be received in a later period, when its amount is deducted from accrued revenues.
Examples
- Accrued expense allows one to match future costs of products with the proceeds from their sales prior to paying out such costs.
- Deferred expense (prepaid expense) allows one to match costs of products paid out and not received yet.
- DepreciationDepreciationDepreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
matches the cost of purchasing fixed assets with revenues generated by them by spreading such costs over their expected life.
Accrued expenses
An accrued expense is a liability used—according to matching principle—to enable management of future costs with an uncertain timing or amount.For example, supplying goods in one accounting period
Accounting period
An accounting period is a period with reference to which United Kingdom corporation tax is charged. It helps dictate when tax is paid on income and gains...
by a vendor, but paying for them in a later period results in an accrued expense that prevents a fictitious increase in the receiving company's value equal to the increase in its inventory
Inventory
Inventory means a list compiled for some formal purpose, such as the details of an estate going to probate, or the contents of a house let furnished. This remains the prime meaning in British English...
(assets) by the cost of the goods received, but unpaid. Without such accrued expense, a sale of such goods in the period they were supplied would cause that the unpaid inventory (recognized as an expense
Expense
In common usage, an expense or expenditure is an outflow of money to another person or group to pay for an item or service, or for a category of costs. For a tenant, rent is an expense. For students or parents, tuition is an expense. Buying food, clothing, furniture or an automobile is often...
fictitiously incurred) would effectively offset the sale proceeds (revenue
Revenue
In business, revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. In many countries, such as the United Kingdom, revenue is referred to as turnover....
) resulting in a fictitious profit in the period of sale, and in a fictitious loss in the latter period of payment, both equal to the cost of goods sold.
Period costs, such as office salaries or selling expenses, are immediately recognized as expenses (and offset against revenues of the accounting period
Accounting period
An accounting period is a period with reference to which United Kingdom corporation tax is charged. It helps dictate when tax is paid on income and gains...
) also when employees are paid in the next period. Unpaid period costs are accrued expenses (liabilities) to avoid such costs (as expenses fictitiously incurred) to offset period revenues that would result in a fictitious profit. An example is a commission earned at the moment of sale (or delivery) by a sales representative who is compensated at the end of the following week, in the next accounting period. The company recognizes the commission as an expense
Expense
In common usage, an expense or expenditure is an outflow of money to another person or group to pay for an item or service, or for a category of costs. For a tenant, rent is an expense. For students or parents, tuition is an expense. Buying food, clothing, furniture or an automobile is often...
incurred immediately in its current income statement
Income statement
Income statement is a company's financial statement that indicates how the revenue Income statement (also referred to as profit and loss statement (P&L), statement of financial performance, earnings statement, operating statement or statement of operations) is a company's financial statement that...
to match the sale proceeds (revenue), so the commission is also added to accrued expenses in the sale period to prevent it from otherwise becoming a fictitious profit, and it is deducted from accrued expenses in the next period to prevent it from otherwise becoming a fictitious loss, when the rep is compensated.
Deferred expenses
A Deferred expense (prepaid expenses or prepayment) is an assetAsset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
used to enable management of costs paid out and not recognized as expenses according to the matching principle.
For example, when the accounting period
Accounting period
An accounting period is a period with reference to which United Kingdom corporation tax is charged. It helps dictate when tax is paid on income and gains...
s are monthly, an 11/12 portion of an annually paid insurance
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...
cost is added to prepaid expenses, which are decreased by 1/12 of the cost in each subsequent period when the same fraction is recognized as an expense
Expense
In common usage, an expense or expenditure is an outflow of money to another person or group to pay for an item or service, or for a category of costs. For a tenant, rent is an expense. For students or parents, tuition is an expense. Buying food, clothing, furniture or an automobile is often...
, rather than all in the month in which such cost is billed. The not-yet-recognized portion of such costs remains as prepayments (assets) to prevent such cost from turning into a fictitious loss in the monthly period it is billed, and into a fictitious profit in any other monthly period.
Similarly, cash paid out for (the cost of) goods and services not received by the end of the accounting period
Accounting period
An accounting period is a period with reference to which United Kingdom corporation tax is charged. It helps dictate when tax is paid on income and gains...
is added to the prepayments to prevent it from turning into a fictitious loss in the period cash was paid out, and into a fictitious profit in the period of their reception. Such cost is not recognized in the income statement
Income statement
Income statement is a company's financial statement that indicates how the revenue Income statement (also referred to as profit and loss statement (P&L), statement of financial performance, earnings statement, operating statement or statement of operations) is a company's financial statement that...
(profit and loss or P&L) as the expense
Expense
In common usage, an expense or expenditure is an outflow of money to another person or group to pay for an item or service, or for a category of costs. For a tenant, rent is an expense. For students or parents, tuition is an expense. Buying food, clothing, furniture or an automobile is often...
incurred in the period of payment, but in the period of their reception when such costs are recognized as expenses in P&L and deducted from prepayments (assets) on balance sheets.
Depreciation
DepreciationDepreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
is used to distribute the cost of the asset over its expected life span according to the matching principle. If a machine is bought for $100,000, has a life span of 10 years, and can produce the same amount of goods each year, then $10,000 of the cost of the machine is matched to each year, rather than charging $100,000 in the first year and nothing in the next 9 years. So, the cost of the machine is offset against the sales in that year. This matches costs to sales.
See also
- Accrual basis accounting
- Revenue recognitionRevenue recognitionThe revenue recognition principle is a cornerstone of accrual accounting together with matching principle. They both determine the accounting period, in which revenues and expenses are recognized...
- Accruals
- DeferralDeferralDeferred, in accrual accounting, is any account where the asset or liability is not realized until a future date , e.g. annuities, charges, taxes, income, etc. The deferred item may be carried, dependent on type of deferral, as either an asset or liability...
s in accrual accounting