Matching Principle – an expense must be recorded in the period it is incurred to match recording of the related income in the period it is earned.
Applications of the matching principle includes recording of prepayments and depreciation.
Prepayments
There are cases where we already paid for an expense that we have not yet incurred; or purchasing items that can still be consumed in the future such as office supplies.
Meaning, we must identify whether we will record an expense or we will book an asset. Matching principle tells us to record the expense in the period it is incurred.
Example 1: In July 1, 2016 Company A paid for advertising expense of $600 covering July to September 2016 services.
Two methods can be used to book prepaid expense, the (1) asset method and (2) the expense method.
Asset method is to record payment initially as an asset under a Prepaid Expense Account and then record the expense portion at end of the period. This is commonly used approach when recording a prepaid expense.
The Expense method on the other hand is to book the transaction as an expense and record the adjustment for the asset portion.
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When payment was made in July 1 2016, the expenses pertains to advertising costs for three months. Therefore, expenses should be allocated from July to September.
The journal entries at month-end for July to September under :
1 Asset Method - to record the expense for the month
2. Expense Method - to record the asset portion of the expense. This will be recorded as a reversing entry.
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Depreciation
Asset such as machineries, equipment, building, furniture, fixtures, vehicles would have a useful life of more than one year. When we make a purchase, we do not record this as an expense but an asset because it will benefit the current and future period.
What is depreciation? This is to allocate the cost of an asset over its useful life. In accounting, we use a contra-asset account to record depreciation; we call this Accumulated Depreciation. Remember that assets have a normal balance of debit since this is a contra-asset account, its normal balance is credit.
What is useful life? These depreciable assets are subject to wear and tear or obsolescence. The useful is the estimated number of years on which the asset is expected to remain in service to the company’s business operation.
How to compute for depreciation? There are different methods to depreciate an asset, the most commonly used is the straight-line depreciation. This is to divide the cost of the asset over the useful life.
Example: Cost is $10,000 ; Estimated Useful Life = 36 months or 3 years
Sometimes we consider the salvage value in our computation. Salvage value is the estimated value of the asset at the end of its useful life. This salvage value should be net of any expected disposal expenses.
Example : Cost is $10,000 ; Estimated Useful Life = 36 months or 3 years; Salvage Value $500
Book value of the equipment presented in the balance sheet is asset cost less depreciation.
Matching Principle is very much related to accrual concept.