Matching Principle requires that expenses incurred by an organization must be charged to the income statement in the accounting period in which the revenue, to which those expenses relate, is earned.
Prior to the application of the matching principle, expenses were charged to the income statement in the accounting period in which they were paid irrespective of whether they relate to the revenue earned during that period. This resulted in non recognition of expenses incurred but not paid for during an accounting period (i.e. accrued expenses) and the charge to income statement of expenses paid in respect of future periods (i.e. prepaid expenses). Application of matching principle results in the deferral of prepaid expenses in order to match them with the revenue earned in future periods. Similarly, accrued expenses are charged in the income statement in which they are incurred to match them with the current period’s revenue.
A major development from the application of matching principle is the use of depreciation in the accounting for non-current assets. Depreciation results in a systematic charge of the cost of a fixed asset to the income statement over several accounting periods spanning the asset’s useful life during which it is expected to generate economic benefits for the entity. Depreciation ensures that the cost of fixed assets is not charged to the profit & loss at once but is ‘matched’ against economic benefits (revenue or cost savings) earned from the asset’s use over several accounting periods.
Matching principle therefore results in the presentation of a more balanced and consistent view of the financial performance of an organization than would result from the use of cash basis of accounting.
Examples of the use of matching principle in IFRS and GAAP include the following:
- Deferred Taxation
IAS 12 Income Taxes and FAS 109 Accounting for Income Taxes require the accounting for taxable and deductible temporary differences arising in the calculation of income tax in a manner that results in the matching of tax expense with the accounting profit earned during a period.
- Cost of Goods Sold
The cost incurred in the manufacture or procurement of inventory is charged to the income statement of the accounting period in which the inventory is sold. Therefore, any inventory remaining unsold at the end of an accounting period is excluded from the computation of cost of goods sold.
- Government Grants
IAS 20 Accounting for Government Grants and Disclosure of Government Assistance requires the recognition of grants as income over the accounting periods in which the related costs (that were intended to be compensated by the grant) are incurred by the entity.
Matching Vs Accruals Vs Cash Basis
In the accounting community, the expressions ‘matching principle’ and ‘accruals basis of accounting’ are often used interchangeably. Accruals basis of accounting requires recognition of income and expenses in the accounting periods to which they relate rather than on cash basis. Accruals basis of accounting is therefore similar to the matching principle in that both tend to dissolve the use of cash basis of accounting.
However, the matching principle is a further refinement of the accruals concept. For example, accruals basis of accounting requires the recognition of the estimated tax expense in the current accounting period even though the actual settlement of the provision may occur in the subsequent period. However, matching principle would also necessitate the recognition of deferred tax in the accounting periods in which the temporary differences arise so as to ‘match’ the accounting profits with the tax charge recognized in the accounting period to the extent of the temporary differences.
How much do you know about matching principle?
Take the free quiz below and find out!
ABC PLC is an insurance company operating in the United States. ABC PLC receives insurance premium in advance from its customers. The profit before tax of ABC PLC for the year ended 31st December 2012 is $100,000 whereas the estimated taxable profit amounts to $110,000 against which a current tax provision of $44,000 (@ 40%) has been recognized in the financial statements. The difference of $10,000 between accounting profit and taxable profit is due to prepaid income which is taxable on cash basis.
How much income tax expense must ABC PLC recognize during the year ended 31st December 2012 in accordance with the Matching Principle?
($110,000 x 40% = $44,000)
The income tax charge for the period must include deferred tax adjustment of $4,000 to reduce the tax expense to the amount necessary to bring it in line with the accounting profit.
($44,000 [current tax] less $4,000 [deferred tax] = $40,000
$4,000 of the estimated current tax charge relates to prepaid income which shall be recognized in the subsequent accounting period. Consequently, $4,000 must be subtracted from the tax expense calculation and matched against the accounting profit earned in the next year. Therefore, the tax expense for the year of $40,000 may also be derived by applying the tax rate of 40% to the profit before tax of $100,000.
($44,000 [current tax] plus $4,000 [deferred tax] = $48,000
The $4,000 in respect of tax attributable to the prepaid income is a temporary difference which is deductible against future tax payments and should therefore be deducted from the tax expense calculation for 2012.