The Matching Principle: Cost Paired With Its Revenue

The matching principle puts a cost in the same period as the revenue it helped produce, whatever the payment date. Paper bought in March and printed into notebooks sold in June is a June cost. Insurance paid for twelve months is spread across those twelve months. Costs that cannot be traced to any particular revenue, such as the rent, are charged to the period they belong to instead.

Here is the idea sitting underneath. Profit is a verdict on a stretch of trading. Something was given up, something came back, and the profit figure is what is left when one is set against the other. The verdict only means anything if the giving up and the getting back are counted inside the same stretch. Charge the effort in one year and count the reward in the next, and the result is two reports, neither of which describes a year anybody actually lived through.

By the end of this guide the reader can say which of two dates decides where a cost is charged, work out how much of a twelve month insurance payment belongs to a six month stub of a year, explain why a full year of salary is charged even when part of it is still unpaid, say what happens to paper that is bought but not yet printed on, spread one machine across the years it will help earn in, and put a number on how badly a set of accounts reads when the principle is ignored.

What does the matching principle actually require?

The idea starts on a footpath, not in a set of accounts. A vegetable seller buys a sack of onions on Monday morning for Rs 900/-. He sells half the sack on Monday for Rs 700/- and the other half on Tuesday for Rs 700/-. Asked how Monday went, he will not say he lost Rs 200/-. In his head, the onions still in the sack on Monday night are not Monday's cost. So he will say he sold half a sack and made a little over two hundred rupees on it. The onions are Tuesday's cost, sitting in a sack, waiting.

The matching principle is that instinct written down as a rule: a cost belongs to the period in which the revenue it helped produce is recognised, not the period in which the money for it left the bank. The seller does it without being taught. The gap between paying and earning stretches from a few weeks to several years. A business with a printing unit, a store full of paper and a machine that will run for a decade cannot do it by instinct. So it is written down, applied line by line, and checked at the year end.

The rule's silence matters just as much. The rule does not say a cost is charged when the invoice arrives, and it does not say a cost is charged when it is paid. Both of those are facts about pieces of paper and about a bank. The rule points at a third thing entirely, the revenue, and asks each cost a single question: which sales did this cost help make happen? The answer to that question, and nothing else, decides the year.

Why does a cost wait for its revenue rather than being charged when it is paid?

Because a payment date answers a different question from the one profit is asking. Anjani Stationers, an invented printer of school notebooks with one printing unit and one delivery van, writes a cheque on 1 October for Rs 4,00,000 of insurance. The cheque is a complete and honest fact. The cheque records exactly when Anjani Kulkarni's bank balance fell, and the record of payments will show it on that date for ever. The cheque cannot say which twelve months of printing that insurance protected, and that is the only thing the profit figure needs to know.

Every cost is asked two separate questions, and only the second one decides which year carries it. The first question is when the money moved, and its answer belongs entirely to the record of payments. The second question is which revenue the cost helped produce, and its answer decides the period the cost is charged in. Keeping the two questions apart is most of the discipline. A great deal of confused accounting is one question being answered when the other was asked.

What happens when a cost is paid before the revenue arrives?

It waits. Anjani Stationers pays Rs 4,00,000 on 1 October for twelve months of cover running from that date. The books close on 31 March. The months of cover fall as October, November, December, January, February, March. Six of the twelve months of cover fall inside this year, and the remaining six fall inside the next. Half the payment therefore bought protection for notebooks that have already been printed and sold, and half bought protection for notebooks that do not exist yet.

Where a cost is paid before the revenue it will help produce arrives, the unused part is held on the balance sheet as an asset and charged in the later period, so Rs 2,00,000 of the insurance is this year's expense and Rs 2,00,000 is not. The Rs 2,00,000 still to come is a prepaid expenseAn amount already paid for a service or a benefit that has not been received yet. It sits on the balance sheet as an asset until the benefit is actually used up, and only then becomes an expense., and Meera Rao, the accountant who comes in three days a week, will carry it forward and charge it next year as the cover is used up. Nothing has been hidden. The money left on 1 October, and everyone can see that it did.

Draw the same fact a second way and the balance sheet half becomes obvious. One payment goes in at the left. Two amounts come out at the right, and they are not two payments. The two amounts are the single payment cut at the point where the year ends, one part labelled expense and one part labelled asset. Look at where the asset part goes rather than at how large it is: it does not disappear and it is not a loss, it simply sits and waits for the year that will use it.

What happens when the revenue arrives before the cost is paid?

The mirror case, and the one people find harder. Anjani Stationers' staff earned Rs 54,00,000 of salary during the year. At 31 March, Rs 3,00,000 of that, the March salary, has not yet been paid, so only Rs 51,00,000 has actually left the bank. The work, though, was done. Notebooks were printed in March with those hands, and those notebooks were billed to schools inside this year. The revenue has already been counted.

Where the revenue has been recognised but the cost has not yet been paid, the cost is charged in full anyway and the unpaid part is carried as a liability, so the salary charge for the year is Rs 54,00,000 and not Rs 51,00,000. The Rs 3,00,000 owed is an accrued expenseA cost that has been incurred but not yet paid or even billed. It is charged to the period in which it was incurred and shown as an amount owed until the payment is made.: charged now, paid later. Matching works in both directions, and that symmetry is the whole reason the rule is worth stating rather than leaving to instinct. A rule that only deferred costs would be a rule for making profit look good.

Watch the ordinary version of this and it stops feeling technical. A household hires a plumber on the last Saturday of the month and pays him on the third of the next. Nobody in that household thinks the leak was fixed in the new month. The work and the benefit sat in the old one, and the payment simply caught up later. Anjani Stationers' March salary is the same shape at a larger size.

Why does paper still sitting in the store not count as a cost yet?

Because a cost is charged against the revenue it produced, and paper that has not been printed on has not produced anything. Anjani Stationers began the year with Rs 16,00,000 of paper and ink already in the store, bought another Rs 1,32,00,000 during the year, and had Rs 22,00,000 left at 31 March. Add the first two and take away the third: Rs 16,00,000 plus Rs 1,32,00,000 less Rs 22,00,000 is Rs 1,26,00,000. The figure, not the Rs 1,32,00,000 of buying, is the paper cost of this year's notebooks.

Stock is matching made visible: the cost of materials waits inside the store until the goods made from them are sold, and only the sold part becomes the year's cost of goods soldThe cost of the materials and production that went into the goods actually sold in a period. It excludes anything still held as stock, which waits until it is sold.. Two moves happen at once here and they are easy to run together. Because those notebooks were sold this year, the opening stock is last year's waiting cost finally being charged. Because those notebooks will be sold next year, the closing stock is this year's waiting cost being pushed forward. Both moves are the same principle, just seen from opposite ends of the year.

What happens to a cost that will help produce revenue for ten years?

It gets divided. Anjani Stationers' printing machine cost Rs 30,00,000 and was paid for before year one even began. The machine will help print notebooks for an estimated ten years. Charging the whole Rs 30,00,000 against the first year would say something plainly untrue: that all ten years of printing capacity were consumed in twelve months. Charging nothing at all would say something equally untrue: that the machine is running for free.

A cost that helps produce revenue across several periods is divided across those periods, so the machine contributes Rs 3,00,000 to each of the ten years rather than Rs 30,00,000 to one. The estimated ten years is the machine's useful lifeThe number of years a business expects to get productive use out of an asset. It is an estimate made by the business, not a fact read off the invoice, and it can be revised if the expectation changes., and it is an estimate made by Anjani Stationers rather than a fact printed on the invoice. The machine's carrying amountThe amount at which an asset is still shown in the accounts: its cost less everything charged against profit so far. It is a record of cost not yet used up, not a valuation. is simply cost that has not been used up yet, sitting on the balance sheet as what remains uncharged. It is the same waiting seen with the insurance and the paper, stretched over a decade instead of six months.

What happens to a cost that cannot be traced to any revenue at all?

Some costs refuse to attach to a product. Anjani Stationers pays Rs 12,00,000 of rent for the year on the printing unit. There is no honest way to work out how much of that rent belongs to one particular notebook. The rent did not go up when an extra thousand notebooks were printed, and it would not have fallen if a school had cancelled an order. The rent bought twelve months of a roof, and that is all it bought.

Where a cost cannot be traced to any particular revenue, it is matched to time instead of to output and charged in full to the period it covers. Accountants split costs into two groups for exactly this reason. A product costA cost that attaches to a unit of output, such as the paper and ink in a notebook. It waits inside the value of stock until that unit is sold. attaches to a unit of output and waits inside the value of the stock until that unit is sold. A period costA cost that attaches to a stretch of time rather than to a unit of output, such as rent or an office salary. It is charged to the months it covers, whether or not anything was sold. attaches to a stretch of time and is charged to the months it covers, sold or unsold. Rent, office salaries and the audit fee all sit in the second group.

The everyday version is a shop that pays Rs 30,000/- of monthly rent and buys its stock separately. The shopkeeper knows the biscuits waiting on the shelf are not this month's cost. The month has gone and it does not come back. He also knows the rent absolutely is, whether he sold two biscuits or two thousand. The distinction is worth holding on to: the second group is where costs quietly become period costs by default when nobody can trace them.

Where does matching become a judgement rather than a calculation?

Across the four cases the certainty drains away. Splitting insurance six months to six months is arithmetic anybody can check against a calendar. Counting the paper left in the store is a physical count. Charging the full Rs 54,00,000 of salary is a matter of reading a payroll register. Then comes the machine, and somebody has to decide that it will last ten years rather than eight or fifteen, and that single decision moves Rs 3,00,000 of cost between years without any external fact changing at all.

Matching is exact where the revenue can be pointed at and becomes an estimate the moment the revenue is spread, uncertain or still in the future. The estimate is not a defect that better accounting would remove. There is no fact anywhere in the world about how many years a printing machine will keep earning, so the alternative to an estimate is not certainty but silence, and silence would leave the machine costing nothing at all. The honest position is that the estimate exists, that it is disclosed, and that a reader who wants the figure a different way can rework it.

The other place judgement enters is the cut-offThe rule that fixes which side of the year end a transaction falls on. A delivery made on 31 March and one made on 1 April belong to different years, and deciding which is which is a genuine test of the records., the line between one year and the next. A delivery van that leaves the printing unit at eleven at night on 31 March and reaches a school at half past midnight has put revenue in one year and, if nobody is careful, its costs in another. Multiplied by every consignment in the last week of March, that is the reason auditors spend a disproportionate amount of time on a handful of days.

What do Anjani Stationers' four costs look like side by side?

Here they are together, one row for each of the four timing cases, all inside the same twelve months. Read the table before the picture. The right hand column carries the real lesson: four costs, four different amounts charged in year one, and in no single case does the amount charged equal the amount that left the bank.

Only the rent lines up. Every other row has a gap between what was paid and what was charged, and every one of those gaps is the principle doing its work. Add up the year and Anjani Stationers reports Rs 38,00,000 of profit before tax: Rs 1,14,00,000 of gross profit less Rs 54,00,000 of salaries, Rs 12,00,000 of rent, Rs 2,00,000 of insurance, Rs 5,00,000 of depreciation on the machine and the van together, and Rs 3,00,000 set aside against an overdue school. Every one of those five deductions is a matching decision.

What does ignoring the principle do to a reported year?

Suppose Anjani Kulkarni decides the whole business is overcomplicated and tells Meera Rao to charge every cost on the day the cheque clears. He is not trying to mislead anyone. His reasoning is that the bank statement is the only document nobody can argue with, so an expense register built from it must be the most honest one available. Watch what that produces.

Two items move. The Rs 2,00,000 of insurance that belonged to next year is charged this year instead. The Rs 22,00,000 of paper still lying in the store is charged this year instead of against the notebooks it will become. Together that is Rs 24,00,000 pulled out of year two and dropped into year one. Year one's profit falls from Rs 38,00,000 to Rs 14,00,000. Year two's rises from Rs 38,00,000 to Rs 62,00,000. Not one extra notebook has been printed or sold.

Now look at the two years as a picture rather than as a pair of figures. The shape is what a reader actually reacts to. Under matching, the line is flat: the same trade produces the same profit twice. Under charging as paid, the same trade produces a line that starts low and climbs steeply, and a steep climb is read as growth by almost everybody who sees one.

How does a lender, an analyst or a household actually use the matching principle?

A lender uses it as a test of the accounts before it uses anything in them. When a credit officer at a bank reads Anjani Stationers' file, the first thing worth checking is whether the swing between two years came from trade or from placement. The check is small: look for the amounts paid in advance, the amounts owed but unpaid, and the closing stock, and ask whether they moved in step with sales or jumped on their own. A closing stock that doubles while sales are flat has moved Rs 22,00,000 of cost into the future, and the profit figure has to be read with that in mind.

An analyst uses the principle in reverse, as a list of the places where a reported profit could have been shifted without anybody breaking a rule. There are only a handful: what is held as paid in advance, what is accrued, what is left in stock, and how many years long assets are spread over. The four lines are where two businesses doing identical trade can report different profits, so an analyst reads them before reading the profit itself. Anjani Stationers charges Rs 3,00,000 a year on a machine it thinks will last ten years. Another printer with the same machine and a fifteen year estimate would charge Rs 2,00,000 and report Rs 1,00,000 more profit, on exactly the same notebooks.

A household uses the same instinct without the vocabulary. A year's school fees paid in April does not make April a catastrophic month and the following eleven unusually good ones. The months become comparable to each other only if the fee is spread in the mind, month by month. Matching is that habit made into a rule, applied line by line, and then written down so that a stranger reading the accounts arrives at the same picture the household already had.

Anjani Stationers Private Limited, Anjani Kulkarni, Meera Rao and the schools they supply are invented.
Educational material. Not advice on any investment, tax, budget or market position.