What term describes a business when revenue earned and costs incurred, in a given period are equal?

5 Min. Read

March 28, 2019

Matching principle is an accounting principle for recording revenues and expenses. It requires that a business records expenses alongside revenues earned. Ideally, they both fall within the same period of time for the clearest tracking. This principle recognizes that businesses must incur expenses to earn revenues.

Here’s everything you need to know about utilizing the matching principle in accounting:

Here’s What We’ll Cover:

What Is the Matching Concept in Accounting?

Example of Matching Principle

What Is Revenue Recognition Principle?

What Are the Benefits of Matching Principle?

What Are the Challenges of Matching Principle?

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). The cause and effect relationship is the basis for the matching principle. If there’s no cause and effect relationship, then the accountant will charge the cost to the expense immediately.

What Is the Matching Concept in Accounting?

Matching principle is especially important in the concept of accrual accounting. Matching principle states that business should match related revenues and expenses in the same period. They do this in order to link the costs of an asset or revenue to its benefits.

Example of Matching Principle

The expense must relate to the period in which the expense occurs rather than on the period of actually paying invoices. For example, if a business pays a 10% commission to sales representatives at the end of each month. If the company has $50,000 in sales in the month of December, the company will pay the commission of $5,000 next January.

Some businesses follow the matching principle. These businesses report commission expenses on the December income statement. Other companies use a cash basis of accounting. In this case, they report the commission in January because it is the payment month. The alternative is reporting the expense in December, when they incurred the expense.

Apart from commissions, some other examples of matching principles are:

• Depreciation
• Wages
• Employee bonuses

What Is Revenue Recognition Principle?

The revenue recognition principle is another accounting principle related to the matching principle. It requires reporting revenue and recording it during realization and earning. This happens regardless of when they make a payment. In other words, businesses don’t have to wait to receive cash from customers to record the revenue from sales.

For example, if you’re a roofing contractor and have completed a job for a customer, your business has earned the fees. This is regardless of when the customer pays you for the job.

What Are the Benefits of Matching Principle?

Businesses primarily follow the matching principle to ensure consistency in financial statements. For example, the income statement, balance sheet, etc.

Recognizing expenses at the wrong time may distort the financial statements greatly. A business may end up with an inaccurate financial position of its finances. The matching principle helps businesses avoid misstating profits for a period.

For example, recognizing expenses earlier than is appropriate results in lower net income. Recognizing an expense later may result in a higher net income than actual. 

Certain financial elements of business also benefit from the use of the matching principle. Long-term assets experience depreciation. The matching principle allows distributing an asset and matching it over the course of its useful life in order to balance the cost over a period. 

For example, a piece of specialized equipment may cost $25,000. It may last for ten or more years, so businesses can distribute the expense over ten years instead of a single year.

What are the Challenges of Matching Principle? 

This principle is an effective tool when expenses and revenues are clear. However, sometimes expenses apply to several areas of revenue, or vice versa. Account teams have to make estimates when there is not a clear correlation between expenses and revenues. For example, you may purchase office supplies like pens, notebooks, and printer ink for your team. These items are necessary, but may not correlate to revenue.

On a larger scale, you may consider purchasing a new building for your business. There’s no way to tell if a larger space or better location improves revenue. Are employees more productive? Is it easier for customers to get to your business? There is no direct relationship between these factors and a new building. Because of this, businesses often choose to spread the cost of the building over years or decades. 

For example, a business spends $20 million on a new location with the expectation that it lasts for 10 years. The business then disperses the $20 million in expenses over the ten-year period. If there is a loan, the expense may include any fees and interest charges as part of the loan term. This disbursement continues even if the business spends the entire $20 million upfront. 

Another example includes online search ads. A marketing team crafts messages to entice potential customers to visit a business website. The customer may not make a purchase until weeks, months, or years later. But they planted a seed nonetheless. It’s not always possible to directly correlate revenue to spending in these cases. Expenses for online search ads appear in the expense period instead of dispersing over time.

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Learn about financial statements and reports including profit and loss, cash flow and balance sheets.

On this page

Financial statements are historical. They show you how your business has been operating in areas such as profitability, cash flow, assets and liabilities.

There are 3 major financial statements to understand:

• profit and loss statement
• balance sheet
• cash flow statement.

These statements are important to help you:

• meet your regulatory requirements
• understand and manage the overall success of your business
• plan for future growth.

You should produce financial statements regularly and keep them up to date.

Profit and loss statements

A profit and loss statement, also known as an income statement, shows the profitability of your business over a specific period. It can cover any period of time, but is most commonly produced monthly, quarterly or annually.

A profit and loss statement is a useful tool for monitoring business activity.

• As a business owner, it highlights where your business is succeeding and where it may be struggling.
• For investors, it shows the financial health of a business before they decide to invest, or to see what return they are getting on an existing investment.

Contents of a profit and loss statement

Your profit and loss statement will generally be split into 2 sections:

• Revenue—all income from your
  • primary business activities (e.g. sales of products and services)
  • secondary activities (e.g. bank interest)
  • any other financial gains (e.g. profit on sale of assets).
• Expenses—what you're spending on primary activities (e.g. material and labour costs), secondary activities and any other losses during the period (e.g. losses on disposal of assets).

Revenue

The most important part of the revenue section of your profit and loss statement is total sales. Secondary revenue and other income can be unpredictable, so you should focus on your primary sales revenue to grow your business.

Secondary sources of revenue can include:

• bank interest
• financial gains (e.g. profit on sales of property or assets).

Note how much sales have risen or fallen since your previous profit and loss statement.

Breaking sales figures down into individual products or product lines will help you see which products are performing well and which products need attention.

Always look to maintain or increase revenues over time. A pattern of falling revenue may indicate that your business is in trouble.

Expenses

The 2 main sets of figures in the expenses section of a profit and loss statement are:

• cost of goods sold (the cost of direct labour and any raw materials used to produce your goods or services)
• operating expenses (the cost of indirect labour and any other costs not directly linked to producing goods or services).

Aim to minimise your business costs wherever possible. Rising material costs could mean you need to find a different supplier, or find more efficient production methods. Some increases are inevitable, with inflation likely to cause costs to increase across a market over a period of time.

Operating expenses can be harder to reduce. For example, if your rent rises it may not be practical to move to alternative premises, or moving may be more expensive than paying the increased rent amount.

Check your profit and loss statement for any sudden or unexpected spikes in costs, rather than gradual increases over time (due to factors such as inflation and annual employee pay rises).

How to calculate profit

Use your profit and loss statement to extract important figures to explain your business's profitability:

• Gross profit = Total revenue - Cost of goods sold
  This is the difference between total sales and the cost of producing the goods or services you sell. This is an indicator of overall production efficiency and a key figure for setting prices and sales targets.
• Gross profit margin = (Gross profit ÷ Total revenue) x 100
  This shows what proportion of gross profit you keep from each dollar of revenue generated (e.g. 20% gross profit margin means you keep a gross profit of $0.20 for every $1.00 of revenue generated).
• Operating profit = Gross profit - Operating expenses
  This shows profit generated from core operations. It does not include expenses from interest or taxes (often called earnings before interest and tax, or EBIT).
• Net profit = Total revenue - (Costs of goods sold + Operating expenses)
  This is also known as the 'bottom line'—net profit is the total amount earned (or lost) after paying all expenses.

Balance sheets

A balance sheet (also known as a statement of financial position) is a summary of all your business assets (what your business owns) and liabilities (what your business owes). At any point in time, it shows you how much money you would have left over if you sold all your assets and paid off all your debts. This is also known as ‘owner's equity’.

There are 3 sections in a balance sheet, represented by the following:

Formula: Owner's equity = Assets - Liabilities

It is called a balance sheet because, at any given moment, each side of this equation must 'balance' out.

Assets

Current assets are assets your business plans to keep for a short period of time, usually less than 12 months. They include:

• cash at bank
• short-term investments
• stock
• trade debtors (people who owe the business money)
• petty cash.

Fixed assets are assets your business plans to keep for a longer period, usually more than 12 months. They are also called non-current or capital assets. They include:

• building improvements
• plant and equipment
• motor vehicles
• office equipment.

Intangible assets are assets you can't touch and can include:

• intellectual property—knowledge, information or processes that set your business apart from others
• trademarks and patents—formally registered concepts that bring value to your business
• goodwill—the amount you pay for the reputation and performance of a business if you buy one, sometimes called 'business value'.

Learn more about how to value business assets.

Liabilities

Current liabilities are usually things you will pay for during the next 12 months. They may include:

• overdrafts that must be settled, or overdraft charges
• short-term loans
• creditors, including trade creditors
• taxes.

Non-current liabilities are things that you will not pay for, or pay off, within a year of your balance sheet date. They include:

• long-term loans
• secured bills
• director's loans (to the business)
• residual value on leases or loans due in more than 12 months.

Owner's equity, also called shareholders' equity in companies, is the remaining portion of a business that belongs to the owner(s) after deducting total liabilities from total assets.

Make sure you consider depreciation when interpreting your balance sheet. Every time your business uses a fixed asset—such as office equipment or a vehicle—some of its value is lost.

Australian tax law requires you to spread the cost of assets over the years in which you use them (depreciation).

A cash flow statement shows how much cash is moving in and out of your business over a period of time. This reflects the 'liquidity' of your business.

Having enough cash available to pay your debts and buy materials and assets is an important part of business planning. A cash flow statement will quickly tell you if you are likely to have any issues in this area.

Cash flowing in is most often the money you get from sales, but it may also be from:

• debt repayments
• selling unnecessary assets
• rebates
• grants.

Your outgoing cash includes expenses such as:

• payments to suppliers
• wages and super
• bills
• maintenance
• other business expenses.

Read more about managing cash flow and cash-flow invoices and payments.

There are normally 3 sections in a cash flow statement, each relating to a different area of your business.

This section contains the main cash-generating activities of your business. This is generally any money earned or spent in the day-to-day running of your business.

The largest figure in this section should be the net income generated by sales of the goods or services you produce.

Accounts receivable (money owed to you) and accounts payable (money you owe) will also appear in this section. If accounts receivable are increasing at a faster rate than income from sales, you may have a problem managing your debtors.

This section measures the flow of cash between your business and its owners and creditors.

Cash income in this section can include:

• any funds borrowed
• public issues of shares or bonds.

Cash expenditure in this section can include:

• loan repayments
• dividends paid out
• re-purchased shares or bonds.

Investing activities listed in this section generally include purchases or sales of long-term assets, such as property, plant and equipment. Include the sale or purchase of investment securities here.

Your cash flow statement may include a few or many items, depending on the size and complexity of your business. The most important figure is your net cash flow, found at the bottom of the statement.

Compare this figure with the net cash flow from your previous statement. If your cash reserves:

• increase, this usually indicates your business is healthy and heading in the right direction
• stay roughly the same, there may only be problems if your reserves are low
• decrease, you may find it difficult to pay your debts and need to rely more heavily on credit. Take immediate action to resolve what is causing your cash shortfalls.

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• Last reviewed: 20 Dec 2021
• Last updated: 20 Dec 2021