There’s a common concept in business that you have to spend money to make money. The matching principle offers a way to recognize this idea in accounting. So, what is the matching principle in accounting, and when is it used?
Understanding the matching principle
The matching principle is part of the Generally Accepted Accounting Principles (GAAP), based on the cause-and-effect relationship between spending and earning. It requires that any business expenses incurred must be recorded in the same period as related revenues. In other words, it formally acknowledges that business must spend money in order to earn revenue.
Accrual accounting is based on the matching principle, which defines how and when businesses adjust the balance sheet. If there is no cause-and-effect relationship leading to future related revenue, then the expenses can be recorded immediately without adjusting entries.
How the matching concept in accounting works
The purpose of the matching principle is to maintain consistency across a business’s income statements and balance sheets. Here’s how it works:
Expenses are recorded on the income statement in the same period that related revenues are earned.
Liabilities are recorded on the balance sheet at the end of the accounting period.
Expenses not directly tied to revenues should be reported on the income statement in the same period as their use.
When expenses are recognized too early or late, it can be difficult to see where they result in revenue. This can potentially distort financial statements and give investors an unclear view of the overall financial position. For example, if you recognize an expense too early it reduces net income. On the other hand, if you recognize it too late, this will raise net income.
What is revenue recognition?
You could look at the matching concept in accounting as a blend of accrual accounting methods and the revenue recognition principle.
According to the revenue recognition principle, revenue must be recognized and recorded on the income statement when it’s earned or realized. Businesses don’t have to wait for the cash payment to be received to record this sales revenue. An example of revenue recognition would be a contractor recording revenue when a single job is complete, even if the customer doesn’t pay the invoice until the following accounting period.
Matching principle example
To better understand how this concept works in the real world, imagine the following matching principle example.
A cosmetics company uses sales representatives, who earn a 10% commission on their sales at the end of each month. For the month of November, the company earned £100,000 in sales, and they will pay their sales reps £10,000 in resulting commission fees in December.
According to the matching principle, both the commission fees (expenses) and cosmetic sales (related revenue) must be recorded in the same accounting period. This means that both should be recorded in the November income statement.
By contrast, if the company used the cash basis of accounting rather than accrual, they would record the revenue in November and the commission in December.
Matching principle benefits
There are several benefits to using the matching principle when preparing your financial statements:
Consistency across financial statements, including the balance sheet and income statement
Greater accuracy when representing the company’s financial position
Less chance of misstating profits during a particular accounting period
Depreciation costs can be distributed over time
Matching principle limitations
On the other hand, some businesses might choose the cash accounting method instead of accrual, in which case the matching principle might not be the best choice. There are some limitations to this concept, including the following:
More challenging when there is no direct cause-and-effect relationship between revenues and expenses
Doesn’t work as well when related revenue is spread out over time, as with marketing or advertising costs
Still, these are limited situations where it becomes more difficult to use. Overall, it’s a good idea to understand the matching principle for the purpose of day-to-day accounting.
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