I was having a discussion on social media with someone about this. It shows why the matching principle exists for financial reporting. The basic premise was someone said they had signed $x money on new contracts for the month and expenses were $y. They failed to mention the $x was going to be earned over time as the jobs are completed and the relates expenses would also come in more over time.
In the above example, the first statement made it sound like profit margins were 80% (very high) but in reality it is around 26% once everything shakes out and is completed (home service business) as the person clarified this later on in the thread.
The matching principle in accounting is a fundamental concept that dictates that expenses should be recognized in the same period in which the related revenues are recognized. This principle is part of the accrual basis of accounting, as opposed to the cash basis, and it helps to provide a more accurate picture of a company's financial position and performance.
So, above the report should read how much revenue was actually recognized in month 1 and how much related expenses were recognized (recognized just means earned or incurred (expenses).
Accrual accounting is mandated for the following:
- Public Companies: All publicly traded companies must use accrual accounting to report their financial results. This is to ensure that external stakeholders, such as investors and regulators, receive a clear and consistent picture of the company's financial performance and condition.
- Large Private Companies: Large private companies, especially those that seek to borrow money or that have a diverse group of stakeholders, are often required by lenders or investors to use accrual accounting.
- Companies with Credit Transactions: Businesses that engage in credit transactions, where the exchange of goods and services occurs in a different period from the associated cash transactions, must use accrual accounting to properly match revenues and expenses.
- Tax Requirements: Some tax authorities require companies that exceed a certain revenue threshold to use accrual accounting for tax purposes.
- Complex Financial Situations: Companies with complex financial transactions, such as those dealing with long-term contracts, advanced financial instruments, or multinational operations, may be required to use accrual accounting to more accurately reflect their financial situation.
The matching principle is relevant for several reasons:
- Revenue Recognition: It ensures that revenues are matched with the costs that were incurred to generate those revenues. This helps in assessing the true profitability of an organization during a specific time period.
- Financial Reporting Accuracy: By recognizing expenses in the same period as the associated revenues, financial statements reflect a company's financial status more accurately.
- Decision Making: Accurate matching of expenses with revenues provides better information for management, investors, and creditors to make informed decisions.
- Prevents Misstatement: It prevents the misstatement of earnings, which can occur if expenses are not recorded in the period when the related revenue is earned.
- Compliance: The matching principle is required by Generally Accepted Accounting Principles (GAAP), which companies must follow to stay compliant with financial reporting standards.
As for the origin of the matching principle, it was not the brainchild of any single individual. Instead, it evolved over time as part of the development of accounting standards and practices. It is a principle that has been shaped by the collective efforts of many accounting theorists and practitioners over the years, as well as by the bodies responsible for setting accounting standards, such as the Financial Accounting Standards Board (FASB) in the United States.
The concept of the matching principle has roots that can be traced back to the early days of commerce, but it was only formalized into accounting theory in the 19th and 20th centuries as the profession became more structured and standardized.
Article found in Accounting and Finance.
