What accounting principle states that if revenue is recorded in an accounting period?

There’s a common concept in business that you have to spend money to make money. The matching principle offers a way to recognize this idea in accounting. So, what is the matching principle in accounting, and when is it used?

Understanding the matching principle

The matching principle is part of the Generally Accepted Accounting Principles (GAAP), based on the cause-and-effect relationship between spending and earning. It requires that any business expenses incurred must be recorded in the same period as related revenues. In other words, it formally acknowledges that business must spend money in order to earn revenue.

Accrual accounting is based on the matching principle, which defines how and when businesses adjust the balance sheet. If there is no cause-and-effect relationship leading to future related revenue, then the expenses can be recorded immediately without adjusting entries.

How the matching concept in accounting works

The purpose of the matching principle is to maintain consistency across a business’s income statements and balance sheets. Here’s how it works:

1. Expenses are recorded on the income statement in the same period that related revenues are earned.

2. Liabilities are recorded on the balance sheet at the end of the accounting period.

3. Expenses not directly tied to revenues should be reported on the income statement in the same period as their use.

When expenses are recognized too early or late, it can be difficult to see where they result in revenue. This can potentially distort financial statements and give investors an unclear view of the overall financial position. For example, if you recognize an expense too early it reduces net income. On the other hand, if you recognize it too late, this will raise net income.

What is revenue recognition?

You could look at the matching concept in accounting as a blend of accrual accounting methods and the revenue recognition principle.

According to the revenue recognition principle, revenue must be recognized and recorded on the income statement when it’s earned or realized. Businesses don’t have to wait for the cash payment to be received to record this sales revenue. An example of revenue recognition would be a contractor recording revenue when a single job is complete, even if the customer doesn’t pay the invoice until the following accounting period.

Matching principle example

To better understand how this concept works in the real world, imagine the following matching principle example.

A cosmetics company uses sales representatives, who earn a 10% commission on their sales at the end of each month. For the month of November, the company earned £100,000 in sales, and they will pay their sales reps £10,000 in resulting commission fees in December.

According to the matching principle, both the commission fees (expenses) and cosmetic sales (related revenue) must be recorded in the same accounting period. This means that both should be recorded in the November income statement.

By contrast, if the company used the cash basis of accounting rather than accrual, they would record the revenue in November and the commission in December.

Matching principle benefits

There are several benefits to using the matching principle when preparing your financial statements:

• Consistency across financial statements, including the balance sheet and income statement

• Greater accuracy when representing the company’s financial position

• Less chance of misstating profits during a particular accounting period

• Depreciation costs can be distributed over time

Matching principle limitations

On the other hand, some businesses might choose the cash accounting method instead of accrual, in which case the matching principle might not be the best choice. There are some limitations to this concept, including the following:

• More challenging when there is no direct cause-and-effect relationship between revenues and expenses

• Doesn’t work as well when related revenue is spread out over time, as with marketing or advertising costs

Still, these are limited situations where it becomes more difficult to use. Overall, it’s a good idea to understand the matching principle for the purpose of day-to-day accounting.

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If your business uses accrual accounting, you should know and understand the revenue recognition principle, sometimes known as the revenue principle.

Why not take a few minutes and learn more about the revenue recognition principle and why it is important to your business.

Overview: What is the revenue recognition principle?

No matter what type of accounting your business is using, the revenue recognition principle remains the same.

The revenue recognition principle says that revenue should be recorded when it has been earned, not received. The revenue recognition concept is part of accrual accounting, meaning that when you create an invoice for your customer for goods or services, the amount of that invoice is recorded as revenue at that point, and not when the money is received from the customer.

This is one of the major differences between accrual basis accounting and cash basis accounting, since with cash accounting, revenue is recognized when payment is received, not when it’s earned.

Requirements for revenue recognition

The revenue recognition principle requires that you use double-entry accounting. Here are some additional guidelines that need to be followed in regards to the revenue recognition principle:

1. An arrangement or agreement is in place between your business and your customer. What this means is that you have offered credit terms to your customer, and they have agreed to pay the invoice in the amount of time in order to fulfill those terms. For instance, you provide consulting services to Client A, with credit terms of Net 30. If Client A accepts those terms, they agree to pay your invoice within 30 days of the date of the invoice.
2. The product or service that you are selling has been delivered or completed. This is one of the most important components of the revenue recognition principle, which is that revenue is recognized and recorded when services are rendered or the product delivered. In essence, this means that your portion of the agreement is complete.
3. The cost has been determined. When you offer your services or sell products to clients, you must provide them with the cost of those services or products, with the cost finalized prior to recognizing the revenue.
4. The amount billed is collectible. This is fairly straightforward and speaks to the importance of accurately vetting clients to determine their creditworthiness. Before you offer credit terms to clients, you should be reasonably sure that you can collect the balance due from them at a future date. This is not foolproof of course, because even properly vetted companies can pay their bills late at times, but this should be the exception, not the rule.
5. If you have doubts about the collectability of an invoice, it should not be recognized as revenue. This is a tough one, since it’s unlikely that you will extend credit terms to a customer that you don’t think will be able to pay their bill. However, if this issue does arise, you should delay recognizing the revenue until the bill has been paid.
6. If payment is received in advance of products or services, the revenue should be recognized only after services are rendered. For instance, if your business provides office cleaning services for $500 a month, and your customer pays you $1,500 for the next three months, the revenue would be recognized at $500 for the next three accounting cycles, rather than being recognized in total for the current accounting cycle.

What does the revenue recognition principle mean for businesses?

The revenue recognition principle enables your business to show profit and loss accurately, since you will be recording revenue when it is earned, not when it is received.

Using the revenue recognition principle also helps with financial projections; allowing your business to more accurately project future revenues. Recognizing revenue properly is also important for businesses that receive payment in advance of services, such as businesses that provide service contracts that require payment up front.

In order to recognize revenue properly, any business that receives payment upfront for services to be rendered must recognize that revenue only after the services have been performed. For instance, if you offer a yearly support contract to your customers for $12,000 annually, you would recognize revenue in the amount of $1,000 monthly for the next 12 months.

Example 1

This is to record the initial customer deposit of $12,000.

Example 2

This is to record the January payment since it has now been earned.

In Example 1, you would debit your cash account, since the money will be deposited. However, instead of applying it to an income account, you would place it in a Client Prepayment account, which will be gradually reduced until the complete $12,000 has been earned.

In Example 2, you would debit the Client Prepayment account, since you are reducing the balance by $1,000, while crediting your income account for the month of January, continuing to do a journal entry each month through the month of December in order to properly account for the earned revenue.

Example of the revenue recognition principle

Here are two simple revenue recognition examples:

1. Your business provides tax services for a client. Once their tax return has been completed, you forward a copy of your invoice to your client, who has agreed to pay the bill within the next 30 days (net 30). You can recognize the revenue immediately, since the services have already been delivered.
2. You provide monthly accounting services for your client. That client pays you in advance for the entire year, with payment received January 2 for the entire year. Remember, you can only recognize revenue as it’s earned, so while you can recognize earned revenue for January, you will have to wait until February in order to recognize February’s revenue, with revenue recognized each month through December, as services are rendered.

Why understanding the revenue recognition principle is important

In order to produce accurate financial statements, it’s important to understand and properly use the revenue recognition principle. Using this principle allows you to record your revenue as it’s earned, thus providing a more accurate profit and loss statement, a must if you’re looking for investors or business financing.

If you’re currently in the market for small business accounting software that will help you better track revenue, be sure to check out The Ascent’s accounting reviews.

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What accounting principle states that if revenue is recorded in an accounting period its corresponding expense should also be recorded in the same accounting period?

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