The matching principle governs expense recognition. It states that all costs that were incurred to generate the revenue appearing on a given period’s income statement should appear as an expense on the same income statement. In other words, we should match expenses against revenues. Revenues are first recognized and expenses are then matched with those revenues. By doing this, the income statement contains measures of both accomplishment (revenue) and effort (expenses), thereby enabling an assessment of firm performance. The matching principle is implemented in one of three ways, explained below.
Associating Cause and Effect
One method of implementing the matching principle is known as associating cause and effect. This implies that a clear and direct relationship exists between the expense and the associated revenue. Cost of goods sold is a good example. A retail store certainly cannot generate sales revenue without consuming inventory. Salespersons’ commissions are another example. Because commissions are usually paid as a percentage of sales revenue, commission expense is tied directly to revenue.Systematic and Rational Allocation
Another method used to implement the matching principle is systematic and rational allocation. Many costs cannot be directly linked to specific revenue transactions. They can, however, be tied to a span of years and allocated as an expense to each of those years. Sales equipment, as an example, is essential to generate revenue. However, linking the cost of each display case, piece of furniture, and the like to specific sales transactions is difficult. Instead, the equipment’s cost is systematically allocated as depreciation expense to the years during which the equipment helps generate revenue.Immediate Recognition
The final method of applying the matching principle is immediate recognition. Some expenditures have no discernible future benefit. In these cases, the expenditure is expensed immediately. Officers’ salaries, utilities, and interest are treated in this manner.Reality Check below addresses revenue and expense issues for Cendant Corporation.
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