What Is the Matching Principle and Why Is It Important?

To better understand how this concept works in the real world, imagine the following matching principle example. For example, a piece of specialized equipment may cost $25,000. It may last for ten or more years, so businesses can distribute the expense over ten years instead of a single year. AccountDebitCreditCOGS160-Deferred COGS-160To revisit the topic introduced at Time 5, COGS may be understated if you expected the RMA in step Time 5 to be a scrap event. However, as explained, you should create an explicit scrap by receiving the RMA into a scrap subinventory. Time 1 to time 2 transactions are the same as those in scenario 1. Assume a corporation produces 100 books at the cost of $4,000.

There’s no way to tell if a larger space or better location improves revenue. There is no direct relationship between these factors and a new building. Because of this, businesses often choose to spread the cost of the building over years or decades.

Advantages of the Matching Principle

An expense is the outflow or using up of assets in the generation of revenue. The income statement displays the product costs that account managers match to the revenue and current period costs. The matching concept is one of the most fundamental accounting principles. According to the matching principle, a corporation must disclose an expense on its income statement in the same period as the relevant revenues. Companies can use the accrual accounting method or the cash method when preparing their financial statements; however, if a company is public, it must use the accrual accounting method as specified by GAAP. This can be important for showing investors the sales revenue the company is generating, the sales trends of the company, and the pro-forma estimates for sales expectations. In contrast, if cash accounting was used, a transaction would not be recorded for a while after the item leaves inventory.

Another example of the matching principle is how to properly record employee bonuses, a type of expense indirectly tied to revenue. The first question you should ask when using the matching principle is whether or not your expenses are directly or indirectly related to generating revenue. The answer will change the way you apply the matching principle. Both adjusted entries and the matching principle help organize information already in your books. In other words, you don’t need an industrial-grade eraser to make an entry. Instead, you’ll simply make a new entry with the latest information. The matching principle of GAAP requires revenues be matched with ___.

Matching principle limitations

This matches the expense of the asset with the revenues that it generates. Using the matching principle, costs are also properly accounted for, resulting in more accurate financial statements. Because the items generated revenue, the local shop will match the cost of $1,000 with the $6,000 of revenue at the end of the accounting period. So, the expense and the revenue will be booked in September, when the revenue was generated. However, the matching principle matches expenses with the revenue they helped generate, as opposed to being recorded in the period the actual cash outflow was incurred. Liabilities are recorded on the balance sheet at the end of the accounting period.

When A/R invoices and recognizes revenue for kit K1, costing first performs a check to determine whether all of the kit’s items have been shipped. No invoice will be created for the shipment, and the accounted amount will remain in the deferred COGS account until the sales order line is closed in Oracle https://personal-accounting.org/ Order Management. The closing of a sales order line with uninvoiced items creates an assumption that revenue has been recognized outside of the normal process, or that revenue will never be recognized. In either case, costing moves the uninvoiced amount from the Deferred COGS account to COGS.

COGS Recognition and Concurrent Processes

The allocation method can be used by businesses to match such expenses to revenue. However, matching the expenses to the earnings might sometimes be challenging.

In this case, they report the commission in January because it is the payment month. The alternative is reporting the expense in December, when they incurred the expense. Because the cash basis of accounting does not match expenses incurred and revenues earned in the appropriate year, it does not follow Generally Accepted Accounting Principles . The cash basis is acceptable in practice only under those circumstances when it approximates the results that a company could obtain under the accrual basis of accounting. Companies using the cash basis do not have to prepare any adjusting entries unless they discover they have made a mistake in preparing an entry during the accounting period. 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.

Examples of the Matching Principle

Revenue on the customer acceptance sales order is 50 percent recognized. This can occur when contract contingencies or other revenue recognition rules require partial recognition. An RMA for 2 units pegged to the originating sales order is received into inventory and costing books the full amount of the RMA into deferred COGS. This process must be run before the Generate COGS recognition Event concurrent process.

• As a result, one cannot favor accrual accounting over the principle.
• The operating cycle of a company is the average time that is required to go from cash to a.
• The profits reported under the principle are more consistent throughout reporting periods, reducing huge variations.
• When expenses are recognized too early or late, it can be difficult to see where they result in revenue.
• When this occurs, Cost Management moves the balance of the sales order line from deferred COGS to COGS.
• The matching principle allows distributing an asset and matching it over the course of its useful life in order to balance the cost over a period.

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 the gaap matching principle requires revenues to be matched with accounting period. Under GAAP and IFRS, a corporate bookkeeper recognizes revenue by debiting the customer receivables account and crediting the sales revenue account.

Matching Principle for the Cost of Goods Sold

This is the system used by individuals when budgeting household expenses and by some small businesses. The matching concept or revenue recognition concept is not used in the cash accounting method. There are situations in which using the matching principle can be a disadvantage. It requires additional accountant effort to record accruals to shift expenses across reporting periods.