The Income statement. Understanding the matching principle.

by J Victor on August 21st, 2010

Matching principle is one of the fundamental accounting principles followed by accountants worldwide. To understand matching principle, we will look at two business transactions first -

Transaction 1-

You run a whole sale super market. There is a 20% profit in every sale you make. There are many retailers who buy in bulk, mostly on credit. One such customer buys goods worth 5 lakhs on credit, on March 31 (last day of the financial year). Definitely, you have made a sale. Goods have gone from your go down and the stock reports will show goods worth 5 lakhs dispatched. Fine. But, on the other hand, the customer has not paid anything and hence the 5 lakhs sale will not bring in a penny to your bank account. There is also a probability that the customer can delay or default in his payments. In such a scenario, can we consider this as a sale in this financial year? If this is recorded as a sale, your revenue statement will show an additional 1 lakh as profit for which you are supposed to pay income tax. Whereas in reality, you have not got a penny.

Transaction 2 –

On the very same day (March 31 st ) salary for the month is to be paid. There is a total of Rs 50,000 to be paid. It is an expense to be deducted from the profits of that accounting year. But, since salary is always paid on the 5 th of every month,the amount remains in your bank. Nothing has been paid. Should we add this as an expense of this year? If this is recorded as an expense, your expense will increase but at the same time you have not paid a penny from your bank account.

What’s the right decision?

In the first case, it is a sale and the transaction should be recorded. That’s because, if we look closely, we will understand that the profit has been already made although there is a delay in realizing the money. This sale was made due to the effort of your employees in the month of March. Hence, the second transaction should also be recorded in this financial year. The salary of 50,000 payable in March is an expense (payment delayed because due date is on 5th) against the profit of Rs 1 lakh made ( receipt delayed due to the credit policy of the company) .  You actual profit  is Rs 50,000, for which you have to pay tax.

If we do not record both these transactions this year, there are two side effects- for the year ending march 31. your records will show no sale or profit but at the same time, your stock records will show an outflow of goods worth 5 lakhs. Next month, even if you do not make a single sale and close down your business, your accounts will still show a receipt of Rs 5 lakhs and an expense of Rs 50,000. If this carries on, your accounts will finally become a jungle of complications.

So, Accountants don’t mind if the customer has actually paid the cash or not. They don’t mind if an expense like salary is actually paid in cash or not. If it pertains to a particular period, they record it in that period itself. In the balance sheet ( where all receivables (assets)and payables (liabilities) of the company are recorded for the year) the accountant will show Rs 5 lakhs as an asset (cash) receivable and the unpaid salary as a liability to be payable.

Now the picture becomes clear for anyone who goes through the revenue statement and balance sheet. The company has made a sale of 5 lakhs ( will be shown as revenue from sales in the income statement) against which 20% is the profit. So the balance 80% is the purchase cost which will be first deducted from Rs 5 lakhs to arrive at Rs 1 lakh as gross profit. But as they can see in the balance sheet, the entire 5 lakhs is pending to be received. An expense of 50,000 will be shown against this profit. At the same time, the balance sheet will show the expense as a liability payable. Subject to this, the company has made a profit of 50,000 for the year.

Why do accountants do like that?

The reason lies in a concept called ‘matching principle’. Matching principle says – that appropriate costs should be matched to the sales for the period represented in the income statement. Knowledge of this concept is necessary to understand how accountants arrive at the profit of a business.

Let’s take another example . My business performs consulting service for a client and has billed Rs 50,000 in December 2010 and he pays my bill 3months later on April 2011. I do not have Rs 50,000 as my income because when I perform the service, I also incur some expenses in the form of salary, printing, electricity etc… Let’s assume that my expenses are Rs 15,000 in total. My profit for the year 2010 is Rs 35,000 and I have to pay tax for that amount- irrespective of the fact that my client has paid me Rs 50,000 in April 2011!!

This might seem to be strange for Newbies. Think and you’ll understand. If I don’t ‘match’ my expenses of 2010 to ‘revenues’ of 2010, my financial statements would never show the right picture in any year. It will show a loss of Rs 15,000 in 2010 and a profit of Rs 50,000 in 2011. Although I know the reason, nobody looking at my financial statement would be able to understand why I incurred a loss in one year and a huge profit in the next year.

The above is case a very simplified example. Imagine what would be the result when you have huge volume of bills and number branches all over India? Even I may not understand what has caused too much volatility.

The above discussion brings us to some realities-

• The ‘sales’ or ‘revenues’ or ‘operating income’ you see in the income statement is the value of goods sold or services rendered in a particular year. For example – sale revenue of Rs 300 Crores means that the company has actually ‘sold’ or ‘rendered services’ worth Rs 300 Crores. It doesn’t mean that the company has received 300 Crores in their bank account. Some of the customers may have paid a portion of it.
• The profit shown in the financial statements is based on the above sales figure of Rs. 300 Crores after deducting the expenses incurred. Let’s assume that the expenses (salary etc.) incurred by the company to generate Rs 300 Crores is Rs 140 Crores. The company has made a profit of Rs 160 Crores ‘in papers’. But in reality, since their clients have paid the whole amount, the profit that’s displayed at the end of the revenue statement is basically an estimate. ( we said that earlier in our post components of financial statements that profit is an estimate). The customers have not paid yet, so the profit shown in the statements does not reflect real money. So, a company can be very profitable and still run out of cash!!
• Later, the profit shown in papers will turn into real cash when the customers start paying.
• Let’s see one more application of the matching principle If the company buys a truck in 2010 that it plans to use for 5 years, the full cost of the truck will not be shown as expense in 2010 itself. That’s because, the company is availing the benefit of the truck for the next 5 years and hence, the cost of the truck has to be spread over the next 5 years and should be deducted from the sale proceeds of these 5 years equally.
• The profit and loss account, in fact, tries to measure whether the products or services that a company provides are profitable when each and every expense (whether paid or not) is considered. It has nothing to do with the company’s actual cash inflow and outflow.

That’s matching principle for you. Now we proceed to discuss about the components of income statement. There are basically only 5 components in an income statement. These are 1. sales 2. Direct expenses 3. Gross profit 4. Indirect expenses 5. Net profit. If there are only 5 components, then why does an income statement look very complicated with lots of figures in it? We’ll try to understand all that in our next lesson.

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