Matching Principle

The matching principle means when revenues are generated, the expenses incurred to generate those revenues should be reported in the same accounting period (the same income statement).

This principle is central to accrual accounting, the method required by GAAP, since the cash accounting method merely reports expenses when paid. The matching principle is concerned with matching the revenue recognized for the period with the expenses that caused the revenue under the accrual accounting method, so that the net result is fairly reported for the period.

Since it is sometimes difficult to associate revenue with expenses used to generate it, general guidelines are used to match expenses with revenues.

The Matching Principle and Cause and Effect

The clearest and most straightforward example of matching expenses with revenue is the cause and effect relationship illustrated in cost of goods sold and revenue. When a product is sold, the most direct cost incurred is the cost of the product.

In the case of Sunny Sunglasses Shop, when Sunny sells a pair of sunglasses for $50, the immediate cost for the sunglasses incurred to generate the sale was the $15 paid for the sunglasses. The $15 cost of goods sold is recognized with the $50 sale so that the revenue and costs incurred to generate the sale are reported, or matched, in the same period.

The Matching Principle and Systematic and Rational Allocation

In the absence of such a direct cause and effect relationship, GAAP requires a systematic and rational method to allocate the cost of the asset used to generate income over several years. These other costs are more closely associated with specific accounting periods.

For example, the purchase of an asset with an estimated useful life of five years can be associated with the revenue it helped generate over that same five – year period. The cause and effect relationships between the cost of the asset and the revenue it generates may not be clear, but the estimated useful life of the asset and the periods that it benefits can be systematically and rationally measured.

Asset depreciation is the allocation method that is used to spread the cost and useful life of the asset against the revenue generated from its use. If an asset were purchased for $100,000, instead of reporting a one-time expense of $100,000, thereby under-reporting revenue for the first year, and over-reporting revenue for the following years for which no expense is taken against future revenues, the matching principle requires that depreciation allocate the cost of the asset over the useful life of the asset. In this case, a $100,000 asset with a useful life of ten years and no salvage value would allocate and match $10,000 of deprecation expense for ten years against those revenues for the same accounting periods.

The purpose of depreciation expense is therefore to allocate the cost of the asset over its useful life against the revenue it helped generate. This allocation method prevents revenue from being under reported in one year, and inflated in following years by properly matching reported revenue with the costs incurred to generate that revenue for the same period.

Similarly, prepaid expenses are recognized when consumed. When Sunny purchased a $2,400 insurance policy for the year and issued a January income statement, only the $200 that was consumed in January was reported as an insurance expense on the earnings statement. The balance of $2,200 remained on the balance sheet as a prepaid expense for remainder of the year.

Applying the Matching Principle by Allocation

The allocation method prevents revenue from being under reported in one year, and inflated in following years by properly matching reported revenue with the costs incurred to generate that revenue for the same period.

Examples of costs recognized by systematic and rational allocation include:

  1. Depreciation expense for plant, property, and equipment
  2. Amortization of intangibles
  3. Allocation of prepaid expenses such as rent and insurance

The Matching Principle and Immediate Recognition

If the above measurement principles are unsuitable to the expense, then the costs are expensed in the period in which they are incurred. These include costs for which there is no clear future benefit, the benefit is not certain, and costs for which no allocation method can be devised.

For example, general administration expenses and salaries across departments are not easily identified with the future benefit of revenues, and are thus immediately expensed during the period they are incurred. Immediate recognition also includes accrued expenses such as payroll and rent incurred for the period but not yet paid. Accrued expenses are recorded in the adjusting entries process to match expenses incurred but not paid with revenue generated in the period.

Expenses or Expenditures?

An expenditure is an outlay of cash, while an expense is the portion of an expenditure that generates revenue for the period. Under the matching principle, expenses are reported with revenue and not necessarily entire expenditures for the period.

In the above example, the $100,000 paid for equipment is an initial expenditure. The $100,000, however, is not an expense used to generate revenue for the same period in year one. Rather, the $10,000 allocated against the revenue for each period of the asset’s life is the expense.

Similarly, expenditures made for items with future benefits are classified as prepaid assets and converted to expenses as they are consumed.

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