Why is matching revenues and expenses so important

Here are the two components of the matching principle:. Period costs are the costs that are unrelated or not directly associated with a product. Commissions, rent, wages or office supplies are all examples of period costs. These costs are recorded as expenses on an income statement during the timeframe where they were experienced. For example, if work is done in January, the expense should be recorded in January.

This is the case even if you don't pay the expense until the following month. Expenses need to be recorded when they're incurred rather than when they were paid for. The product cost is the total amount of cost associated with a product in regard to its acquisition and production. The matching principle requires product costs to be recognized in the same timeframe as the one where the revenue was recognized. For example, if a salesperson makes a commission off of their product sales, they would need to invoice the customers in December to match all December costs associated with creating and delivering the products.

Using the matching principle allows for a variety of benefits. Here are a few:. Because of the principle, assets are equally distributed over time and matched to balance the cost. This helps assets avoid depreciation. Another benefit is a more accurate reporting of a business' operating results because the revenues and expenses were matched at the same time.

Overall, the matching principle provides investors with a normalized income state and streamlined information regarding a company's profitability and its ability to efficiently operate.

Along with its benefits, using the matching principle also poses one main disadvantage: When estimates are used, inaccurate reporting occurs. In a similar sense, inflation can affect the utilization of the matching principle. Revenue is accrued based on the current-day price, but over time, the costs become outdated due to various factors like depreciation. Example: Imagine that a bakery wants to expand its building because it believes it will be beneficial for its business.

Because there's no definitive proof that the expansion will be beneficial and profitable, the bakery will take the useful life of the expanded area and depreciate the total cost over that lifetime.

This means the expenses will accrue regardless of if the bakery's expansion is profitable or not. To get a greater sense of the matching principle and its application, here are a few examples:. Depreciation refers to the decrease in value of an asset due to the passage of time and its inevitable wear and tear.

Here are some examples of depreciation about the matching principle:. The computer is expected to last 10 years, meaning it will produce projects for the projected decade.

The price of the computer should then be matched with the revenue it's creating for the company. The cost of the bike will need to be matched with the revenue it's made you. Our comprehensive guides serve as an introduction to basic concepts that you can incorporate into your larger business strategy.

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Use our research library below to get actionable, first-hand advice. The matching principle is part of Generally Accepted Accounting Principles GAAP that states that expenses and related revenues need to be reported in the same period of time. We may receive compensation from partners and advertisers whose products appear here. Compensation may impact where products are placed on our site, but editorial opinions, scores, and reviews are independent from, and never influenced by, any advertiser or partner.

The matching principle is a key component of accrual basis accounting, requiring that business expenses be reported in the same accounting period as the corresponding revenue. The matching principle allows for consistency in financial reporting, working off the premise that business expenses are required in order to generate revenue. The matching principle is a basic, underlying principle in accounting that states that expenses should be reported at the same time as their related revenues.

The matching principle is one of the ten accounting principles included in Generally Accepted Accounting Principles GAAP , stating that businesses are required to match income to related expenses in a specific period of time. Designed to be used with accrual accounting, the matching principle is never used in cash accounting.

In order to understand the matching principle, you should be familiar with the following accounting terms :. One of the benefits of using the matching principle is financial statement consistency. If revenues and expenses are not recorded properly, both your balance sheet and your income statement will be inaccurate. For instance, if you recognize an expense in one month and revenue in the following month, your net income will be understated, while if you recognize revenue in one month, with expenses the following month, your income will be artificially overstated.

Another benefit is the ability to recognize and record depreciation expenses over the useful life of an asset in order to avoid recording the expense in a single accounting period. However, the commission payment will not be processed until the 15th of February. Using the matching principle usually requires an accrual entry.

Here are some additional examples of the matching principle and the adjusting journal entries :. Your current pay period ends on April 24, but your next pay date is May 1.

This accrual reflects the correct amount of payroll expenses for the month of April. This entry will need to be reversed in May, or May payroll expenses will be overstated. Depreciation is the expensing of an asset over its useful life. Depreciation expense reduces income for each period that the expense is recorded. For instance, you purchase a new conveyor belt for your factory. By using the belt in the production process, the belt will be providing monetary benefits to your business.

Expensing a portion of the cost of the conveyor belt over its useful life, you will be using the matching principle as you match any revenue earned with the expense of the asset throughout the life of the asset. Like the payroll accrual, this entry will need to be reversed in May, when the actual commission expense is paid.

Business expense categories such as prepaid expenses use the matching principle in similar fashion as depreciation. This will require two initial journal entries in the month of January, followed by a recurring journal entry for February through December. Instead of expensing this directly to rent, you will record it as prepaid rent. The following journal entry will be recorded each accounting period.

This journal entry displays the rent expense for the month, while reducing the prepaid rent account. This recurring journal entry will be made for each subsequent accounting period until the prepaid rent account has been depleted, which will be in December. Using the matching principle, accounting costs and revenues will be accurate, rather than under- or over-stated. For example, when managing revenue, matching principle usage ensures that any expense incurred in the production of that revenue is properly accounted for in the month that the revenue is generated.

Using the matching principle, costs are also properly accounted for, resulting in more accurate financial statements. It does matter what type of accounting method you employ when using the matching principle. Only the accrual accounting method is able to use the matching principle, since cash accounting does not use the revenue recognition principle that accrual accounting uses. Are you paying more in taxes than you need to? Service Delivery : Delivery of goods or service may not be enough to allow for a business to recognize revenue on a sale if there is doubt that the customer will pay what it owes.

The installment sales method recognizes income after a sale or delivery is made; the revenue recognized is a proportion or the product of the percentage of revenue earned and cash collected.

The unearned income is deferred recorded as a liability and then recognized to income when cash is collected. The installment sales method is typically used to account for sales of consumer durables, retail land sales, and retirement property. The cost recovery method is used when there is an extremely high probability of uncollectable payments. The deposit method is used when a company receives cash before transfer of ownership occurs.

Revenue is not recognized when cash is received because the risks and rewards of ownership have not transferred to the buyer. The seller records the cash deposit as a deferred revenue, which is reported as a liability on the balance sheet until the revenue is earned. For example, sales of magazine subscriptions utilize the deposit method to recognize revenue. As the delivery of the magazines take place, a portion of revenue is recognized, and the deferred liability account is reduced for the amount of the revenue.

Accrual accounting does not record revenues and expenses based on the exchange of cash, while the cash-basis method does. Under the accrual accounting method, the receipt of cash is not considered when recording revenue; however, in most cases, goods must be transferred to the buyer in order to recognize earnings on the sale.

An accrual journal entry is made to record the revenue on the transferred goods even if payment has not been made. If goods are sold and remain undelivered, the sales transaction is not complete and revenue on the sale has not been earned. In this case, an accrual entry for revenue on the sale is not made until the goods are delivered or are in transit. Expenses incurred in the same period in which revenues are earned are also accrued for with a journal entry. Just like revenues, the recording of the expense is unrelated to the payment of cash.

An expense account is debited and a cash or liability account is credited. The cash method of accounting recognizes revenue and expenses when cash is exchanged.

For a seller using the cash method, revenue on the sale is not recognized until payment is collected. Just like revenues, expenses are recognized and recorded when cash is paid.

The Financial Accounting Standards Board FASB , which dictates accounting standards for most companies—especially publicly traded companies—discourages businesses from using the cash model because revenues and expenses are not properly matched. The cash model is acceptable for smaller businesses for which a majority of transactions occur in cash and the use of credit is minimal.

A cashier at a hotel in Thailand : The cash-basis method, unlike the accrual method, relies on the receipt and payment of cash to recognize revenues and expenses.

Privacy Policy. Skip to main content. Detailed Review of the Income Statement. Search for:. Revenue Recognition. The Importance of Timing: Revenue and Expense Recognition Revenue is recognized when earned and payment is assured; expenses are recognized when incurred and the revenue associated with the expense is recognized. Learning Objectives Explain how the timing of expense and revenue recognition affects the financial statements. Key Takeaways Key Points According to the principle of revenue recognition, revenues are recognized in the period earned buyer and seller have entered into an agreement to transfer assets and if they are realized or realizable cash payment has been received or collection of payment is reasonably assured.

The matching principle, part of accrual accounting, requires that expenses be recognized when obligations are 1 incurred usually when goods are transferred or services rendered , and 2 that they offset recognized revenues, which were generated from those expenses.

As long as the timing of the recognition of revenue and expense falls within the same accounting period, the revenues and expenses are matched and reported on the income statement. Key Terms incur : To render somebody liable or subject to. Current Guidelines for Revenue Recognition Transactions that result in the recognition of revenue include sales assets, services rendered, and revenue from the use of company assets.

Learning Objectives Explain how the revenue recognition principle affects how a transaction is recorded. Key Takeaways Key Points Under accrual accounting, revenues are recognized when they are realized payment collected or realizable the seller has reasonable assurance that payment on goods will be collected and when they are earned usually occurs when goods are transferred or services rendered.