The Matching Principle in Accounting

The matching principle or matching concept is one of the fundamental concepts used in accrual basis accounting. Matching principle accounting ensures that expenses are matched to revenues recognized in an accounting period. For this reason the matching principle is sometimes referred to as the expenses recognition principle.

Matching Principle and Accrual Basis of Accounting

The image below summarizes how the matching principle is part of the accrual basis of accounting. A business selects a time period for its accounting (year, quarter, month etc) and uses the revenue recognition principle to determine the revenue for that period. Based on this time period and revenue recognized the matching principle is used to determine the expenses to be included.

Matching Principle and Expenses

The matching principle applies to all expenses. For the purposes of applying the matching principle expenses fall into three groups as follows:

1. Expenses which can be directly associated with revenue such as cost of goods sold and sales commission.
2. Expenses which are not directly associated with revenue such as depreciation and rent.
3. Expenses which have no future benefit such as production costs relating to faulty goods, research costs and general expenses.

Matching Principle Examples

Matching and Expenses Directly Associated with Revenue

Expenses which are directly associated to revenue include items as the cost of goods sold and the sales commission expense.

Cost of Goods Sold Example

Suppose a business has a product which sells for 10.00 a unit and costs 4.00 a unit. If the business decides that its accounting period is one year and it sells 8,000 units in that year, then the revenue recognized is 80,000 (8,000 units x 10.00).

The matching principle states that the cost of goods sold must be matched to the revenue. This revenue was generated by the sale of goods costing 4.00 a unit and therefore the cost of goods sold is 32,000 (8,000 units x 4.00).

```Time period = 1 year (Time period assumption)
Revenue recognized = 8,000 x 10 = 80,000 (Revenue recognition principle)
Expenses = 8,000 x 4.00 = 32,000 (Matching principle)
```

The expense is directly associated with the level of revenue recognized.

Sales Commission Example

A business pays a 5% commission on sales revenue to its sales agents. The business calculates sales commissions on a monthly basis and pays its agents in the following month. In this instance the time period is one month.

Suppose that the revenue recognized for the month of March is 9,000. This revenue was generated by the activities of the sales agents and the matching principle in accounting requires the matching of the sales commission expense to this revenue.

```Time period = 1 month (Time period assumption)
Revenue recognized = 9,000 (Revenue recognition principle)
Expenses = 9,000 x 5% = 450 (Matching principle)
```

The expense is directly associated with the level of revenue recognized.

Note that although the sales commission is not paid until April, based on the matching principle, the sales commission is an expense for the month of March as it has been matched to revenue recognized in that month.

An adjusting entry would now be used to record the sales commission expense and corresponding liability in March.

Matching and Expenses Not Directly Associated with Revenue

Expenses which are not directly associated with revenue are mainly period costs and include items as depreciation, and expenses relating to rent. Since the matching of the expense cannot be linked to the level of revenue there must be a systematic basis for allocating the expense to each time period. It should be noted that in order to be able to allocate the expense to future time periods there must be a clear and expected future benefit to the business.

Depreciation Example

The depreciation expense arises due to a reduction in value of a long term asset caused by its limited useful life.

The asset is used to generate revenue over its useful life. Since there is an expected future benefit from the use of the asset the matching principle requires that the cost of the asset is spread over its useful life. As there is no direct link between the expense and the revenue a systematic approach is used, which in this case means adopting an appropriate depreciation method such as straight line depreciation.

Suppose a business purchases an asset costing 25,000. The asset has a useful life of 5 years and a salvage value at the end of that time of 4,000. The business uses the straight line depreciation method and calculates the annual depreciation expense as follows.

```Asset cost = 25,000
Salvage value = 4,000
Useful life = 5

Depreciation expense = (Cost - Salvage value) / Useful life
Depreciation expense = (25,000 - 4,000) / 5 = 4,200
```

The depreciation expense is 4,200 each year for 5 years

Let’s say the business recognizes revenue of 90,000 in the first year of the assets life. In this instance the expense is not directly associated with the revenue and the matching principle determines that the expense is allocated on a systematic basis by time period.

```Time period = 1 year (Time period assumption)
Revenue recognized = 90,000 (Revenue recognition principle)
Expenses = 4,200 (Matching principle)
```

The expense is not directly associated with the level of revenue recognized.

Rent Example

Rent is normally a period cost which does not vary in relation to the revenue of the business. Since there is an expected future benefit from the payment of rent the matching principle requires that the cost is spread over the rental period. As there is no direct link between the expense and the revenue a systematic approach is used, which in this case means allocating the rent expense equally over the time period to which it relates.

Suppose a business incurs rent of 9,000 each year and pays this rent at the rate of 2,250 at the start of each quarter. The matching principle requires that the rent must be allocated on an appropriate basis to each accounting period. Assuming the business produces accounts on a monthly basis the rent for each time period is therefore 8,000/12 = 750.

Let’s say that the revenue for the month of June is 8,000, irrespective of the level of this revenue the matched rent expense for the period will be 750.

```Time period = 1 month (Time period assumption)
Revenue recognized = 8,000 (Revenue recognition principle)
Expenses = 8,000/12 = 750 (Matching principle)
```

The expense is not directly associated with the level of revenue recognized and is allocated evenly by time period.

It should be noted that although the rent for June is paid in advance on 1 April, based on the matching principle, the rent is an expense for the month of June and is matched to revenue recognized in that month.

An adjusting entry would now be used to record the rent expense and corresponding reduction in the rent prepayment in June.

Matching and Costs which have no Future Benefit

If the costs are expected to have no future benefit beyond the current accounting period then the full amount should be immediately recognized as an expense. Expenses of this type include items such as the production costs relating to faulty goods which cannot be sold, research costs and general expenses.

Production Costs Relating to Faulty Goods Example

Suppose a business produces a faulty batch of 500 units of a product which sells for 6.00 a unit and costs 2.00 a unit. If the units were not faulty the costs would be matched against sales of the product as part of the cost of goods sold (as described above). However, in this instance the units are faulty and will not be sold and therefore the business cannot expect a future benefit from the costs incurred. The matching principle requires that the costs are treated immediately as an expense in the current accounting period.

```Time period = 1 month (Time period assumption)
Revenue recognized = 0 (Revenue recognition principle)
Expenses = 500 x 2.00 = 1,000 (Matching principle)
```

Matching Principle Conclusion

The matching principle in accounting is used to ensure that expenses are matched to revenues recognized during an accounting period. If there is a future benefit expected from the cost incurred then the process of expense matching is carried out by either directly relating the expense to the level of revenue or, where there is no relationship to revenue, by allocating the expense on a time period or other systematic basis.

If a future benefit is not expected then the matching principle requires that the cost is treated immediately as an expense in the period in which it was incurred.

Together with the time period assumption and the revenue recognition principle the matching principle forms a necessary part of the accrual basis of accounting. The alternative method of accounting is the cash basis in which revenue is recorded when received and expenses are recorded when paid.