The matching principle is a fundamental accounting rule for preparing an income statement. It simply states, “Match the sale with its associated costs to determine profits in a given period of time—usually a month, quarter, or year.” In other words, one of the accountants’ primary jobs is to figure out and properly record all the costs incurred in generating sales, including the cost to make and deliver the product and the sales and administrative support.
Because of the matching principle, the expenses on the statement are not necessarily those things that we purchased that month, or even paid for that month.
Here are two examples of the matching principle:
If an ink-and-toner company buys a truckload of cartridges in June to resell to customers over the next several months, it does not record the cost of all those cartridges in June. Rather it records the cost of each cartridge on the income statement when the cartridge is sold.
The matching principle even extends to items like taxes. A company may pay its tax bill once a quarter—but every month the income statement includes a figure reflecting the taxes owed on that month’s profits.
(Excerpts from Financial Intelligence, Chapter 5 – Profit is an Estimate)
Any income statement begins with sales. When a business delivers a product or a service to a customer, accountants say it has made a sale. Never mind if the customer hasn’t paid for the product or service yet—the business may count the amount of the sale on the top line of its income statement for the period in question. No money at all may have changed hands.
And the “cost” lines of the income statement? Well, the costs and expenses a company reports are not necessarily the ones it wrote checks for during that period. The costs and expenses on the income statement are those it incurred in generating the sales recorded during that time period. Accountants call this the matching principle—the appropriate costs should be matched to all the sales for the period represented in the income statement—and it’s the key to understanding how profit is determined.
(Excerpts from Financial Intelligence, Chapter 8 – Costs and Expenses)
Depreciation is an example of the matching principle in action. Depreciation is the “expensing” of a physical asset, such as a truck or a machine, over its estimated useful life. All this means is that the accountants figure out how long the asset is likely to be in use, take the appropriate fraction of its total cost, and count that amount as an expense on the income statement.
In those few dry sentences, however, lurks a powerful tool that financial artists can put to work. Let’s assume our company buys a $36,000 truck in the first full month of operation and expects the truck to last three years, so we depreciate it at $1,000 a month (using a simple straight-line depreciation approach). But our accountants don’t have a crystal ball. They don’t know that the truck will last exactly three years. That’s an assumption they’re making. Alternatively, they might assume the truck will last only one year, in which case they have to depreciate it at $3,000 a month. That one decision might move a start-up company from a profit to a loss.