How does the matching principle affect my profit and loss?

The accounting standards that accountants work from tend to complicate the whole process of running your accounts by using overly technical phrases and telling you that your business has to use things like ‘accrual accounting’ (as if it’s completely obvious what that may mean).

But, in fact, a lot of these confusing, jargon-laden terms can be explained in quite simple ways. ‘The matching principle’ is one of these terms. And, as we’ll explain, once you know what it means, the underlying concept is a relatively easy one to get your head around.

So, pin back your lug-holes and let’s dive into your profit and loss!

What’s the matching principle?

Matching is one of the basic principles in accrual accounting. It’s as simple as making sure that the company expenses on your income statement (that’s your profit and loss report) are in the same period as the related revenues.

So that means recording all your expenses in the month they took place, not when the transfer of cash happened. If you order £100 of paper from a supplier in January, receive their invoice and pay the bill in February then the expense needs to be recorded in January’s numbers.

Still with us? Good, let’s try explaining this matching business in more detail.

Adjusting entries in accrual accounting

Let’s assume you’re running an estate agent business (no need to rush out and buy a loud tie, this is just hypothetical!). The agents all work on a commission basis and will be paid 10% of any revenue resulting from the sale of houses in their portfolio.

Commission is paid to the agents one month in arrears on the last day of each month – so they’re paid their commission from February at the end of March. If Dave (they’re always called Dave) has brought in £20,000 in sales revenue in February, he’ll be due a payment of £2k commission on top of his basic salary on 31 March – nice work, Dave!

If we apply the matching principle, we now need to record that £2k of commission expense in the February income statement, alongside the £20,000 of sales income. The way to do this is with an ‘adjusting entry’, which does exactly what it says on the tin – it adjusts the entry for the last day of February so that it debits your commission expense and credits your commission payable. Remember, with double-entry bookkeeping, any cash that goes out has to be matched with the relevant transaction coming in.

Why is the adjusting entry needed? Well, without applying the matching principle, you’d report the £2k of commission expense in March (the month you’ve actually paid it to Dave) rather than in February (when the sales were made, the expense was generated and the liability was incurred).

And why’s that important? Well, you’d end up with a profit and loss statement that didn’t give a true reflection of when, and how much, you were spending on your commission expenses. To put it bluntly, it would really screw up your numbers!

Allocating costs over time

So, it’s pretty clear why you need to adjust your expenses to make sure they fall in the right period. But not all expenses are this straightforward. For some, there isn’t a simple cause and effect relationship with sales or revenue.

Let’s imagine you’re running a delivery company now. You’ve just bought a shiny new delivery van for £19,200. Based on the mileage you do (and the fact you ride the clutch like a nightmare) you’ve estimated that the van will need replacing in 4 years’ time.

Because you’ll be benefitting from the use of this van over a 4-year window, you can spread the cost of this expense over a 48-month period in your accounting. That means allocating the cost from now, in 2017, until the end of the van’s useful life in 2021. So, each month you’d match the cost of £400 (for the expense associated with your now-less-than-shiny van) with your monthly income statement.

What if I’m self-employed?

If you’re a sole-trader, and this is all sounding like a lot of hard graft, don’t worry – to make things easier for self-employed people, HM Revenue & Customs (HMRC) allows you to keep your records on a cash basis, as opposed to accrual accounting.

In basic terms, doing your books on a cash basis means you record your expenses when the payment is made, not when the original expense took place. This means there’s no need for the adjustment entries or allocations that would be needed for a limited company.

Phew!

Ready for some jargon?

Ok, it’s time to get a little technical with you (don’t worry, it doesn’t hurt). If you can learn a few of the very basic accrual accounting terms, it will help you get a much better handle on your income statement and what’s going on with your costs and spending.

• Accrued expenses – these are expenses where you’ve received the benefit of a product or service but haven’t yet been sent an invoice by your supplier. So, you may have used a marketing agency to run an email campaign, but haven’t been billed. In accountant-speak, you’ve created a liability (to everyone else, you owe some money)
• Prepayments – prepayments come about when you pay for a product/service in advance and get the benefit at some point in the future. So, if you rent your office and pay a month in advance, this would be a prepayment. Because of the forward-looking nature of prepayments, they also become classed as an asset within the business (in theory, you’ve paid in advance, but not used all the service). So you could end up getting a refund if you failed to use the full service you’ve paid for.
• Income in advance – Income in advance is almost the flipside of a prepayment. If you raise a sales invoice for work that you’ll complete in the future, this generates potential revenue (even though you’ve not yet done a minute’s work). In theory, it’s also a liability, as your client could ask for the money back if you don’t deliver! Because of this, the money is only released to your profit and loss once the work’s been completed. This process is given the snappy title of ‘income (or revenue) recognition’. And remember that the costs need to match the income.
• Depreciation – As we mentioned with the delivery van example, you can spread the cost of an asset over its expected life. So when you buy a new computer you don’t get the instant hit on your profit and loss statement – the computer will depreciate (and lose value) over time, and that’s reflected in way the cost is allocated. Xero (our online accounting package of choice) has a brilliant fixed asset register that does all the hard work of working out the depreciation for you.

Knowing your adjustments from your accrual

We’re hoping you now see how accrual accounting works – not as tricky as it sounded, is it?

And we’re confident you can also appreciate how the matching principle helps you get a true, up-to-date view of your profit and loss. Combining this understanding with a basic grasp of the important accounting terms not only demystifies the whole process of what us accountants do, but also gives you a much better handle on your own income statement – and that’s a huge help when you’re making big decisions about the future of the business.

Who are FD Works?

FD Works is an accountancy firm based in Bristol and Bath. If you’re a business owner we want to help you demystify your numbers, empower you to control your finances and work with you to realise your potential.