You keep on hearing this business concept that “Spend money to earn it”. This idea helps you to realise the matching principle concept in accounting. Unlike other financial jargons used by your accountant or bookkeeper, the matching principle concept is simpler to help you get a better insight into your business’s accounts, earning reports, and key performance indicators (KPIs). Let’s see, what is a matching principle accounting, how it works, why it is important and what are its limitations?
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What is the Matching Principle Accounting?
It is one of the fundamental concepts in accrual accounting and is simple to the extent that it ensures the expenses of your business in the income statement (Profit & loss Report) are incurred in the same period as the related revenue. Let’s simplify it a bit more, it implies recording of expenses in the month they occurred rather than recording them when the cash is transferred or paid.
For instance, if you order stationery costing £120 for your office from a retailer in August, get an invoice, but pay it in September. Here, you need to record these expenses in August’s numbers.
This principle is not applicable in cash accounting, in which expenses and revenues are only recorded when cash is received or paid.
How Matching Principle Accounting Works?
We use this principle in accounting to maintain consistency in a business’s financial statement, like income statement and balance sheet and avoid misstating earnings for a period. Here is how this concept works:
- You only record expenses on the income statement in the period when revenues are incurred.
- You record liabilities on the balance sheet at the end of the accounting period.
- Expenses, like general administration and research and development that are not directly related to revenues, need to be reported on the income statement in the same period when they are earned.
If the expenses are recorded at the wrong time, it may be difficult to see how they affect the revenue. This may potentially misrepresent the financial statements and provide a misinterpreted view of the overall financial position of a business. For instance, if you report expenses too early, it will decrease the actual net income. On the contrary, if they’re reported too late, the real net income will increase.
To get a better understanding of the matching principle concept in the real world, you need to imagine the following example. Suppose, a company has sales representatives, who get a 10% commission on sales at the month-end. And on September the company earned around £100,000 in sales, and it’ll be paying its sales representatives £10,000 in resulting commission fees in October.
According to this principle, both expenses (commission) and revenue (sales) need to be recorded in the same period. It implies that both should be recorded in September’s income statement. On the flip side, if a company uses the cash basis of accounting, they would record the revenue (£100,000 in sales) in September and the commission (£10,000) in October.
Here are some of the advantages of this concept while preparing your financial statements:
- Ensures consistency in financial statements (that includes the balance sheet and income statement)
- Provides a more clear and accurate picture of the company’s financial position
- Fewer chances of profits distortion during a particular accounting period
- Depreciation costs can be distributed over time
In some cases, this principle might not work best for all due to the following reasons:
- Accounting becomes complex because of no direct cause-and-effect relationship between revenues and expenses
- It is not suitable to work out when revenue is spread out over time (like with the cost of marketing/advertising )
However, there are only a few instances when it becomes difficult. In general, it is preferred to use this principle for day to day accounting purposes.
Quick Sum Up
So, matching principle accounting requires you to report expenses in the same period wherein they are incurred, without considering the cash transfer. This principle maintains consistency across financial statements and helps avoid misstating of profits. In this way, it provides you with a reliable outlook of the financial health of a company.
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Disclaimer: This blog is written for general information on the topic and must not be taken as expert advice.