The matching concept is an accounting practice whereby firms recognize revenues and their related expenses in the same accounting period. Firms report revenues, that is, along with the expenses that brought them.
The purpose of the matching concept is to avoid misstating earnings for a period. Reporting revenues for a period without reporting all the expenses that brought them could result in overstated profits.
Note especially that applying the matching concept requires accrual accounting, the practice of recognizing revenues when they are earned and expenses when they are incurred. Actual cash flows from these transactions may occur at other times, even in other periods.
Explaining the Matching Concept in Context
Sections below further define, explain, and illustrate matching concept. Note especially that the term appears in context with related terms and concepts, including the following:
- What is the matching concept?
- Who defines the matching concept? Who enforces the concept?
- Define your terms: What is the difference between revenues, expenses, costs, and cash flows?
- What is the role of the matching concept in ROI and other financial metrics?
- The materiality concept in accounting. See Materiality Concept.
- Accrual accounting explained. See: Accrual Accounting.
- Double entry accounting explained. See: Double Entry System.
- For examples showing the use of ROI and other financial metrics in business case analysis, so as to reflect only costs and benefits resulting directly from an action, see:
Sales transactions in business normally include payment timing provisions, such as "Net 30 from receipt of invoice." An invoice with this annotation means that payment is due no later than 30 days from invoice receipt. When a customer is late in paying, however, most companies continue to carry the obligation under "Accounts receivable" for a period of time. During this time, they use various means to encourage the customer to pay (see Bad Debt).
The Decision to Write Off a Bad Debt
Most firms, however, also have a specified cutoff period which may be something like 30, 60, 90, or 120 days, beyond which the firms must choose between two possible actions:
- Firstly, the company may choose to write off the obligation as bad debt.
- Secondly, the company may choose instead to refer the debt to a collection service or to their lawyers for further legal action.
Note that writing off the debt by the accountants does not remove the customer's obligation to pay. Writing off the debt serves only to improve the company's accuracy in accounting.
Firms may also decide to write off a bad debt when it becomes clear for other reasons that the customer will never pay. This can occur when the customer goes out of business, or is sued by other creditors, or simply challenges the legitimacy of the obligation.
Bad Debt Write-Off: Impact on Financial Statements
Certain bad debt write-off actions are standard accounting practice for every firm that uses accrual accounting and a double-entry accounting system. Writing off debt in this way means making two accounting system accounts:
- Firstly, the firm debits the amount of the debt to an account, Bad debt expense. This is a non cash expenses account.
- Secondly, the firm credits the same amount to a contra asset account, Allowance for doubtful accounts.
Writing off debt in this way therefore directly impacts two accounting system accounts: Bad debt expense and Allowance for doubtful accounts. Changes in these accounts, in turn, involve other accounts and the firm's financial reports as follows:
Income Statement Impact
Firms report revenues earned during the period on the Income statement. And, earned revenues include those that are still payable. These are carried in a Balance sheet Current assets account, Accounts receivable. This account is itself is not an Income statement line item, but its balance is part of the Income statement item Total net sales Revenues.
When the period includes a bad debt write off, however, the Income statement does include the Bad debt expense balance as a line item. This normally appears under Operating expenses, below the Gross profit line. As a result, Bad debt expense from a write off lowers Operating profit and bottom line Net income.
Balance Sheet Impact
A bad debt write-off adds to the Balance sheet account, Allowance for doubtful accounts. And this, in turn, is subtracted from the Balance sheet Current assets category Accounts receivable. The result appears as Net Accounts receivable. The write off, in other words means that Net Accounts receivable is less than Accounts receivable.
Statement of Changes in Financial Position (Cash Flow Statement)
Bad debt expense also appears as a non cash expense item on the Statement of changes in financial position (Cash flow statement). Bad debt expense from a write off is subtracted from Sales Revenues, lowering Total Sources of Cash.
Statement of Retained Earnings
Net income (Net profit) from the Income statement impacts the Statement of retained earnings in two ways.
- Firstly, as dividends paid to share holders.
- Secondly, as retained earnings.
At period end, the firm's Board of Directors decides how to distribute Net Income between dividends and retained earnings. Because write off impacts Net income, therefore, the action also lowers dividends and retained earnings on the Statement of retained earnings.
For more on these transactions, and examples, see the article Allowance for Doubtful Accounts.
It is an accounting principle everywhere that assets are to be valued accurately and realistically. In December 2012, however, Research in Motion (RIM) of Canada recognized that the realizable market value of its Blackberry Playbook inventory had fallen well below the company's COGS (Cost of Goods Sold). This, in turn, meant that the inventory would never earn revenues enough to cover its original Balance sheet value. Consequently, RIM took a $485 million write-down on the total book value of the unsold devices. The write-down was necessary to maintain accounting accuracy.
How Do Inventories Lose Value?
In fact, inventory of various kinds can lose value due to quite a few different factors. Inventory write-downs may be necessary, when:
Inventory Market Value Decreases
Market value may be driven lower by lack of customer demand or aggressive pricing by competitors.
Inventory is Stolen
Burglary in the warehouse or shop can result in stolen inventory. However, theft can also result from pilferage by shippers, shoplifters, or the company's own employees.
This kind of inventory loss is so common, and so immune to complete eradication, that many companies call such losses leakage or shrinkage and then regularly report an inventory write-down under one of these names.
Inventory Suffers Damage or Spoilage
Perishable goods such as vegetables, fruits, or cut flowers, for instance, have by nature a short "shelf life." This can be further reduced by inadequate storage and handling. Disasters or accidents can also drastically destroy or lower value.
Items Become Obsolete or Out of Date
Many consumer technology products can command high market prices for a few months at most. Designer fashion clothing commands a high market value only for a relatively short "season" of a few weeks or several months at most. Printed magazines and other dated publications may have high value for no more than a few days.
Accounting for inventory write-down
When inventory loss due to one of these causes is relatively small, the firm can simply report the loss as part of COGS. When the loss is relatively large, however, as in the case of RIM's 2012 write down, the loss impacts the company's other Balance sheet and Income statement accounts.
With a relatively large inventory write-down:
- The firm credits a Balance sheet asset account, such as Finished goods inventory. A credit transaction lowers the value of an asset account.
- Simultaneously, the firm debits an Income statement expense account. The firm could carry, for instance, an expense account for this purpose called "Inventory shrinkage." The expense item in any case appears as an operating expense.
The ultimate impact of these transactions, of course, are to (1) reduce Net income on the Income statement, and (2) Reduce the value of the total asset base on the Balance sheet.
For more on inventory accounting, including inventory write-downs, see the article Inventory and Inventory Management.
Other assets besides "Accounts receivable" and "Inventories" may also be subject to write-off or write-down. This occurs usually when they become worthless or nonproductive. In these cases, a write-off or write-down also means reporting two simultaneous and equal transactions:
- Firstly, as a debit (increase) to an Income statement expense account.
- Secondly, as a credit (decrease) to an asset account.
The laws specifying the kinds of losses and kinds of assets that qualify for loss deduction, and the calculation of loss value, appear in the country's tax code. In the United States, for instance, this is Internal Revenue Code Section 65.
Generally, the kinds of losses that qualify for writing off in this way include:
- Ownership of stock shares that become worthless.
- Theft or vandalism for Property, plant and Equipment or other Capital assets.
- Casualty or catastrophe such as fire, flooding or other natural disaster.