An important concept of accrual accounting is called the Matching Principle. This concept states that the related revenues and expenses must be matched in the same period. This is done in order to link the costs of an asset or revenue to its benefits. It also recognizes that a business must incur expenses to earn revenues.
The principle is at the core of the accrual basis of accounting and adjusting entries. It is a part of Generally Accepted Accounting Principles (GAAP) and based on a cause-and-effect relationship. Without it, an accountant will charge the cost to the expense immediately.
Example
For example, a company makes drones and acquires the components to make them. It acquires the components on May 1st and pays for them on May 31st. They are used to make 100 drones, all of which are sold on June 15th. While the costs associated with the components were incurred and paid for during May, the expense would not be recognized until June 15th - when the drones that the components were used for were sold.
Benefits
The primary reason businesses adhere to revenue and cost matching is to ensure consistency in financial statements, such as the income statement, balance sheet, etc. Recognizing the expenses at the wrong time may distort the financial statements greatly and provide an inaccurate financial position of the business. This helps businesses avoid misstating profits for a period.
Matching costs to revenues present a more accurate picture of a company’s operations on the income statement. Investors/Banks (lenders) typically want to see a smooth and normalized income statement where revenues and expenses are tied together, as opposed to being lumpy and disconnected. By matching them together, lenders get a better sense of the true economics of the business.
It is important to look at the cash flow statement in conjunction with the income statement. Lenders pay close attention to the company’s cash balance and the timing of its cash flows.
Challenges
Matching works well when it’s easy to connect revenues and expenses. There are times, however, when that connection is much less clear, and estimates must be taken.
Imagine, for example, that a company decides to build a new office headquarters that it believes will improve worker productivity. Since there’s no way to directly measure the timing and impact of the new office on revenues, the company will take the useful life of the new office space (measured in years) and depreciate the total cost over that lifetime.
If the office costs $10 million and is expected to last 10 years, the company would allocate $1 million of straight-line depreciation expense per year for 10 years. The expense will continue regardless of whether revenues are generated or not.
Another example would be if a company were to spend $1 million on online marketing. It may not be able to track the timing of the revenue that comes in, as customers may take months or years to make a purchase. In such a case, the marketing expense would appear on the income statement during the time period the ads are shown, instead of when revenues are received.
In working with small to medium-sized business, we have provided advice and guidance for both cost and accrual-based accounting. Related to matching costs and revenues, the benefits include avoiding large monthly jumps in gross margin and cleaner financials to provide banks when applying for financing.
If your company is growing or you just need someone to objectively review or organize your books, we’re here to help. Contact us today at info@vikingadvisorygroup.com for a free initial consultation.