The expenses that are deducted from gross income to arrive at net income of the business are reported on the company’s income statement. The number of expenses and types of expenses that are reported on the income statement varies widely from business to business. Large corporations such as Ford Motor Company could have pages of expenses on its income statement while a small Mom and Pop retail store may have only a handful. Key to the preparation of an accurate profit and loss statement is the “matching” of expenses to the revenues those expenses helped generate.
The matching principle is one of the basic underlying guidelines in accounting. The matching principle directs a company to report an expense on its income statement in the same period as the related revenues.
The matching principle is associated with the accrual method of accounting and adjusting entries. Without the matching principle, a company might report $10,000 of expenses in January (when it is paid) instead of December (when the expense and the liability are incurred). A retailer’s or a manufacturer’s cost of goods sold is another example of an expense that is matched with sales through a cause and effect relationship.
Let us examine how this matching principle impacts the Income Statement for a small retail company. The income statement below shows the income and expenses for Mom’s Flower Shop without matching revenue to expenses for the month of March, 20XX. The owner paid an entire years insurance premium of $3,650 on March 1 and deducted the entire amount as an expense from her March revenue. This gave her net income of $6,052 for the month as shown below.
| Mom’s Flower Shop | |||||
|---|---|---|---|---|---|
| Income Statement, March 20XX | |||||
| Sales Revenue | |||||
| Cash Sales | $24,550 | ||||
| Credit Sales | $850 | ||||
| Cost of Goods Sold | |||||
| Beginning Inventory, 3/1/20XX | $85,250 | ||||
| + Purchases | $2,750 | ||||
| Goods Available for Sale | $88,000 | ||||
| – Ending Inventory, 3/31/20XX | $75,725 | ||||
| Cost of Goods Sold | $12,275 | ||||
| Gross Profit | $13,125 | ||||
| Operating Expenses | |||||
| Advertising | $565.00 | ||||
| Insurance | $3,650.00 | ||||
| Salaries | $1,300.00 | ||||
| Website | $165.00 | ||||
| Repairs & Maintenance | $85.00 | ||||
| Travel | $- | ||||
| Entertainment | $- | ||||
| Total Operating Expenses | $5,765.00 | ||||
| General Expenses | |||||
| Utilities | $275.00 | ||||
| Telephone | $169.00 | ||||
| Professional Fees | $200.00 | ||||
| Postage | $85.00 | ||||
| Payroll Taxes | $279.00 | ||||
| Total General Expenses | $1,008.00 | ||||
| Other Expenses | |||||
| Bad Check Expense | $25.00 | ||||
| Miscellaneous Expense | $275.00 | ||||
| Total Other Expenses | $300.00 | ||||
| Total Expenses | $7,073.00 | ||||
| Net Income | $6,052.00 | ||||
| Mom’s Flower Shop | |||||
|---|---|---|---|---|---|
| Income Statement, March 20XX | |||||
| Sales Revenue | |||||
| Cash Sales | $24,550 | ||||
| Credit Sales | $ 850 | ||||
| Cost of Goods Sold | |||||
| Beginning Inventory, 3/1/20XX | $85,250 | ||||
| + Purchases | $2,750 | ||||
| Goods Available for Sale | $88,000 | ||||
| – Ending Inventory, 3/31/20XX | $75,725 | ||||
| Cost of Goods Sold | $12,275 | ||||
| Gross Profit | $13,125 | ||||
| Operating Expenses | |||||
| Advertising | $565.00 | ||||
| Insurance | $304.00 | ||||
| Salaries | $1,300.00 | ||||
| Website | $165.00 | ||||
| Repairs & Maintenance | $85.00 | ||||
| Travel | $ – | ||||
| Entertainment | $- | ||||
| Total Operating Expenses | $2,419.00 | ||||
| General Expenses | |||||
| Utilities | $275.00 | ||||
| Telephone | $169.00 | ||||
| Professional Fees | $200.00 | ||||
| Postage | $85.00 | ||||
| Payroll Taxes | $279.00 | ||||
| Total General Expenses | $1,008.00 | ||||
| Other Expenses | |||||
| Bad Check Expense | $25.00 | ||||
| Miscellaneous Expense | $275.00 | ||||
| Total Other Expenses | $300.00 | ||||
| Total Expenses | $3,727.00 | ||||
| Net Income | $9,398.00 | ||||
As you can see, recognizing just the portion of insurance that was “used” for March, 20XX increases her net income to $9,398.00 and is a much more accurate representation of the financial performance of the business during the month.
Since net income flows to the statement of owners’ equity, it is important that managers understand the importance of this matching principal since both internal and external stakeholders will use the company’s financial statements for decision making purposes.
