Matching Rule Details

The matching rule follows the accruals basis of accounting, where revenues are recognized when earned, and expenses are recognized when incurred. The accruals basis differs from cash-based accounting, where incomes are recognized when payment is received and costs when cash is paid out. This rule is necessary to prevent financial statements from being skewed. It ensures that all expenses are recognized in the same period as the incomes to which it relates.

The objective of presenting financial statements is to show the company's financial health and to help decision-making. Financial statements must be prepared holistically and accurately. The matching rule ensures that accounts and financial statements are presented in an accurate and fair view. It enables consistency and prevents mismatching of revenues and expenditures for different periods.

The accounting practice of depreciation and amortization is in line with the matching rule. Depreciation refers to the gradual write-off and expensing of a fixed asset and is done every accounting period to progressively bring down the fixed asset's value. The depreciation expense reported in a financial period represents matching the asset's cost to the period in which the business has benefitted from that asset. Disregarding the depreciation expense would require the asset's total cost to be expensed, either during the year of the purchase or when the asset's useful life has been exhausted. Doing so would paint a false picture of the business's state, as a considerable expenditure will be reported in one year and none in subsequent or preceding years.

Example of Matching Rule

Suppose a business makes a sale of $10,000 from which they must pay a sales commission of $1,000 when payment is received. However, the cash is secured in the next financial year, and the commission payment is then paid. The matching concept requires that both the revenue and the commission expense be recognized in the same financial period by matching the cost to the income in which it relates. The commission expense will appear in the books in the same year as the revenue. The business will accrue the commission payment in its books for the first financial year and release the liability from its books when the payment is made.

The matching rule also comes to play for purchases of physical goods and explains why companies recognize stocks at the end of a financial year as assets and not as costs. An electronics dealer purchases equipment worth $50,000 during the year and makes sales of $40,000 after selling equipment that costs $30,000. With cash-based accounting, the company would record a loss of $10,000 (being the sale of $40,000 minus the purchases of $50,000). Reporting a loss in such a scenario would be misleading to users of the financial statements, as the company had not exhausted the sale of the purchased inventory.

With the matching principle, the company would book $40,000 as revenue and match the sales expenses by only registering $30,000 as the purchases. A profit of $10,000 will be reported at the end of the year, being the difference between sales and purchases. The balance of inventory worth $20,000 will then be recorded in the balance sheet as closing inventory.