How is depreciation related to the matching principle

Matching the expenses and revenues allows investors to see consistency in a company's financial statements. Here are the two components of the matching principle:. Period costs are the costs that are unrelated or not directly associated with a product. Commissions, rent, wages or office supplies are all examples of period costs.

These costs are recorded as expenses on an income statement during the timeframe where they were experienced. For example, if work is done in January, the expense should be recorded in January. This is the case even if you don't pay the expense until the following month. Expenses need to be recorded when they're incurred rather than when they were paid for.

The product cost is the total amount of cost associated with a product in regard to its acquisition and production. The matching principle requires product costs to be recognized in the same timeframe as the one where the revenue was recognized. For example, if a salesperson makes a commission off of their product sales, they would need to invoice the customers in December to match all December costs associated with creating and delivering the products. Using the matching principle allows for a variety of benefits.

Here are a few:. Because of the principle, assets are equally distributed over time and matched to balance the cost. This helps assets avoid depreciation.

Another benefit is a more accurate reporting of a business' operating results because the revenues and expenses were matched at the same time. Overall, the matching principle provides investors with a normalized income state and streamlined information regarding a company's profitability and its ability to efficiently operate. Along with its benefits, using the matching principle also poses one main disadvantage: When estimates are used, inaccurate reporting occurs.

In a similar sense, inflation can affect the utilization of the matching principle. Revenue is accrued based on the current-day price, but over time, the costs become outdated due to various factors like depreciation. Example: Imagine that a bakery wants to expand its building because it believes it will be beneficial for its business.

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For small business Overview Improve your cashflow Keep track of payments Reduce costs Reduce failed payments Increase conversions. For enterprise Overview Reduce churn Reduce international barriers Reduce operational costs Reduce time to get paid Reduce conversion risk. Breadcrumb Resources Accountants. Table of contents. 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.

What is revenue recognition? An important concept of accrual accounting, the matching principle states that the related revenues and expenses must be matched in the same period. This is done in order to link the costs of an asset or revenue to its benefits.

The expense must relate to the period in which they were incurred rather than on the period in which they were paid. The matching statement requires that the commission expense is reported in the December income statement. If the company uses the cash basis of accounting, the commission would be reported in January in the month they were paid rather than December the month they were incurred.

The revenue recognition principle is an accounting principle that requires the revenue be recognized and recorded when it is realized and earned, regardless of when the payment is made.

This is regardless of when the customer pays you for the job. The primary reason why businesses adhere to the matching principle is to ensure consistency in financial statements, such as the income statement, balance sheet etc. Select basic ads.

Create a personalised ads profile. Select personalised ads. Apply market research to generate audience insights. Measure content performance. Develop and improve products. List of Partners vendors. While a company's financial reports—the income statement , the balance sheet , the cash flow statement , and the statement of owners' equity —represent the company's financial health and progress, they can't provide a perfectly accurate picture.

Assumptions in depreciation can impact the value of long-term assets and this can affect short-term earnings results. While companies do not break down the book values or depreciation for investors to the level discussed here, the assumptions they use are often discussed in the footnotes to the financial statements.

This is something investors might wish to be aware of. One of the consequences of generally accepted accounting principles GAAP is that, while cash is used to pay for a long-lived asset, such as a semi-trailer to deliver goods, the expenditure is not listed as an expense against revenue at the time.

Instead, the cost is placed as an asset onto the balance sheet and that value is steadily reduced over the useful life of the asset. This reduction is an expense called depreciation. This happens because of the matching principle from GAAP, which says expenses are recorded in the same accounting period as the revenue that is earned as a result of those expenses.

The two main assumptions built into the depreciation amount are the expected useful life and the salvage value. The above example uses the straight-line method of depreciation and not an accelerated depreciation method , which records a larger depreciation expense during the earlier years and a smaller expense in later years.

Figure 1. Suppose that trailer technology has changed significantly over the past three years and the company wants to upgrade its trailer to the improved version while selling its old one. Three scenarios can occur for that sale. The cash account balance will increase by the sale amount for all cases.