Matching principle dictates that entity must recognize expenses in the same period in which it has recognized incomes as earned. It is also called matching concept or expense recognition principle.
In accounting, matching principle is defined with a well known phrase “let the expenses follow the revenues” i.e. recognize expenses in the same period in which relevant revenues were recognized regardless of timing of payments and receipts. This also indicates that expense recognition and revenue recognition work in tandem. To better understand expense recognition we need to understand revenue recognition as it is depending on it.
Entity recognizes revenue when the obligation of performance is executed satisfactorily i.e. the revenue will be recognized in the period of performance. Once revenue is recognized, entity is required to match the expenses that were incurred to generate these revenues.
It is mainly matching concept that drives the accrual concept of accounting as both revenue and expenses are recognized irrespective of the timing of cash receipts and payments.
Application of matching principle require exercise of judgment especially related to probable cash flows in which case estimation is sometimes required. While estimating, conservatism concept greatly helps management to report fairly on incomes and expenses of the period by not overstating or understanding incomes and expenses. For example, if expenses are not recorded until payment is made, then it may case understatement of expenses in one period and overstatement of expenses in the next.
It is however important to understand not all expenses qualify for matching principle i.e. delaying recognition of expense until relevant revenue is recognized. Distinguishing between product costs and period costs is essential. Period costs are recognized immediately and completely irrespective of related revenue.
For example warehouse rentals for storing finished goods are period costs and are recognized in the period rent is payable and are not delayed until units are sold. So matching principle is irrelevant in this case. However, if nature of product requires storage before its ready (like some fruit that require storage to ripen) then it is an inventoriable or product cost and matching principle is applied.
Example: Cost of goods sold
ABC by the year end had a total turnover of 500,000 selling 10,000 units. At the start of the year entity had 1000 units at hand @ 30/unit and bought another 10,000 during the year @ 40/unit. Entity is using FIFO method for inventory valuation.
Revenue recognized for this period is 500,000 whereas cost of goods sold for the period is calculated as following:
[1000 x 30]+[10000 x 40]-[1000 x 40] = 390,000
As 1000 units is unsold from the latest purchase therefore, 40,000 will be deducted from this period’s expense as they are not sold and thus carried forward to next period as asset. It will be deducted from the next period’s revenue on sale of units.