Why the Matching Principle is Important for Small Businesses

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.

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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.

Overview: What is the matching principle?

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:

  • Accrual method: Accrual accounting is one of two accounting methods. The accrual method recognizes income when work is completed, not when money is received, and expenses when they occur, not when they are paid.
  • Cash method: The simpler method of accounting, the cash method recognizes income when payment is received and expenses when they are paid.
  • Expense: Any cost that a business incurs in the process of generating revenue. Expense accounts are considered temporary accounts that are zeroed out at the end of each accounting period in order to start the next period with a zero balance.
  • Revenue: Revenue is income that is generated from regular business activity. Like an expense account, a revenue account is also a temporary account and zeroed out at the end of each accounting period.
  • Journal entry: Journal entries serve as a way of recording necessary business transactions to the appropriate account in a specific accounting period.

What are the benefits of the matching principle?

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.

Matching principle examples

Jim currently employs two sales people, who receive a 10% commission on sales each month. In the month of January, Jim’s business had sales of $9,000, which means that Jim owes his salespeople $900 in commissions for January.

However, the commission payment will not be processed until the 15th of February. In order to abide by the matching principle, Jim or his accountant will need to accrue the $900 expense in January, and later reverse the commission expense in February, after it’s been paid.

By accruing the $900 in January, Jim will ensure that he is in compliance with the matching principle of reporting expenses in the same time period as sales.

If Jim didn’t accrue the $900 in January, his sales of $9,000 would be reported in January, and the related commission expense would be reported in February.

Using the matching principle usually requires an accrual entry. Here are some additional examples of the matching principle and the adjusting journal entries:

1. Wages

Your current pay period ends on April 24, but your next pay date is May 1. The amount of wages your employees earn between April 24 and May 1 amount to $4,150. In order to properly account for these wages in the correct month (April), you will need to accrue payroll expenses in the amount of $4,150.

Date Account Debit Credit
4-30-2020 Payroll Expense $4,150
Accrued Payroll $4,150

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.

2. Depreciation

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.

Date Account Debit Credit
4-30-2020 Depreciation Expense $425
Accumulated Depreciation $425

In order to use the matching principle properly, you will need to record a monthly depreciation expense in the amount of $450 for the next three years, or over the useful life of the equipment.

3. Sales commission

Your sales people earn a 15% commission on all sales. For the month of April, your company had sales in the amount of $27,000. This means that you owe your sales staff a total of $4,050 in commissions for the month of April.

However, the commissions are not due to be paid until May, so you will need to accrue the $4,050 for the month of April since the expense is clearly tied to the sales revenue that was earned in April.

Date Account Debit Credit
4-30-2020 Commission Expense $4,050
Accrued Expenses $4,050

Like the payroll accrual, this entry will need to be reversed in May, when the actual commission expense is paid.

4. Prepaid expenses

Business expense categories such as prepaid expenses use the matching principle in similar fashion as depreciation. For example, in January, your business prepaid annual rent in the amount of $15,000.

However, you don’t want to expense the entire amount in the month of January, since it will overstate expenses in January, while understating them for the subsequent months.

In order to properly use the matching principle for your prepaid expenses, you will record a recurring journal entry in the amount of $1,250 each month for the next 12 months.

This will require two initial journal entries in the month of January, followed by a recurring journal entry for February through December.

Date Account Debit Credit
1-31-2020 Prepaid Rent $15,000
Cash $15,000

The first journal entry is made to record the initial rent payment in the amount of $15,000. 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.

Date Account Debit Credit
1-31-2020 Rent Expense $1,250
Prepaid Rent $1,250

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.

The matching principle is a key component in accrual accounting

If you’re using the accrual method of accounting, you need to be using the matching principle as well. 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.

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