Question:
Discuss about the Matching Principle in Accounting for Vendors and Manufacturers.
Accounting is an important field of managing a company’s finances. As companies grow in size and begin to deal with a large number of clients, vendors, manufacturers and retailers, the managing of their accounts gets more and more difficult. This is when most companies either outsource the management of their finances or they hire a team of full time accountants who can look after the company’s finances and make sure the business is running smoothly and attaining profit.
In accounting, often it happens that mistakes are made while managing finances. These mistakes while can occur due to a number of reasons, some occur due to the improper understanding of the matching principle of accounting. The matching principle of accounting can be described as a guideline which helps businesses in managing their finances by replying their expenses on their respective income statements in the same period of time as the revenue have occurred.
This essay talks in detail about the matching principle as well as how it applies to the relevant case study. The essay tries to explore the drawbacks, limitations and errors that had occurred and how these could have been avoided in the first place. The essay also offers some recommendations relevant to the case study pertaining to the use of the matching principle of accounting.
According to the case study, the firm where I work in happens to have a client of many years. This client happens to be a management accountant. A management accountant may be described as a professional who deals with the interpretation of financial matters and the interpretation of financial information. This interpretation helps the stakeholders of the business in understanding the financial conditions of their business, whether it is incurring profits or losses and the types of risks that are associated with the company’s finances. This client who has been working at the firm for many years had recently also started his own coaching classes. He happens to now be teaching at TAFE as a part time teacher. Lots of professional practitioners who are actually working in the field indulge in rendering educational institutions and the students who study there with their expertise and experience of the real world. This helps the students gain a better insight into the actual field even before they have started working as professionals.
For the purpose of his part time teaching facilities, the client had very recently taken a decision to acquire a property on rent for the same purpose. As he is the client of our firm, we had prepared his tax returns. This tax return had been sent to the client so he could give it a thorough read and further render his approval by returning back the tax return file with his signatures on it. As it happened, the firm discovered that the client had sent the papers back without having signed them.
According to the client, there had been an error on the part of the firm. The client said that there had been an error on the part of the company. He believes that the claiming of the tax deduction had been done wrong. The client had been renting the property for quite a while now but he had not received his rent receipts for the first four months. Therefore, according to him, as he was not earning an income in the first four months of his part time coaching classes, there must be a deduction in the taxes as well. However, this is in contrast to section 6 of tax law and matching principle of accounting. Section 6 of tax law says that “In working out whether you have derived an amount of * ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct” (Anonymous 1997). The matching principle of accounting says that the expenses of a company or a business must be reported in the same month as when the revenue for the same was generated.
A large amount of studies have been carried out in order to arrive at the matching principle of accounting. A huge amount of information is also available on the pros and cons of the same and why the principle should be the way it is. According to the matching principle of accounting, any revenues generated by a business organization and any expenses that are related to those revenues must be recognized together in the same period of time. The matching principle requires that revenues and any related expenses be recognized together in the same period (Watson 2017). Therefore, according to this principle, any cause and effect relation that might occur between the revenues generated and the expenses that occur must be recorded at the same time. In this sense, the matching principle recognizes expenses as the revenue recognition principle recognizes income (Potter 2014). This helps in a number of ways, the first and foremost being that it becomes easier for management accountants to understand and interpret the financial information of a company in a much better, easier and quicker manner. In addition to this, it also usually becomes even easier to recognize the relationship between revenues and expenses on a general basis.
There also might be some cases, where there might not at all be a cause and effect relationship occurring between the revenues and the expenses or classes wherein such a relationship might not be easily recognizable. However, the matching principle of accounting suggests that even when such is the case, it is advisable that the costs be charged to the expenses at once. The matching principle of accounting is based on the accrual system of accounting and therefore the above mentioned suggestion holds relevant to cases such as the one this essay explores in addition to many others. The accrual basis requires the use of allowances for sales returns, bad debts, and inventory obsolescence, which are in advance of such items actually occurring (Bragg 2017). The recording of revenues that are generated within a specified period and the expenses related to it that occurred within the same period helps as the overall effect of a transaction can be recorded in a single period of time. The matching principle also requires that estimates be made, based on experience and economic conditions, for the purpose of providing for doubtful accounts (Nordmeyer 2017). The accrual basis of accounting is different from the cash basis of accounting. The cash basis is a method of recording accounting transactions for revenue and expenses only when the corresponding cash is received or payments are made (Bragg 2017).
According to the client, in this particular case, the firm had committed a mistake by accounting for tax deductions in the first four months of his renting the property. According to him, as he did not incur income or generate any revenues from his part time business in the first four months that he owned the rental property, no expenses can be tied to the same. However, this stands in contrast to the matching principle of accounting.
The client fails to understand that he actually did earn revenue and income in the first four months of his owning the rental property. Even though he did not receive any actual payments in the first four months, the receipts he received in the later months were pertaining to the first four months only. Therefore, these revenues had been generated in the time period that was the four months following when he started the rent of his place. In cash basis accounting, revenues are recorded when cash is actually received and expenses are recorded when they are actually paid (no matter when they were actually invoiced) (Ward 2016).
The firm is correct in its place as it is following the matching principle of accounting. According to section 8 of the tax law which refers to the timing of deduction of taxes, “if what comes in is assessable to you when it has accrued, even if not yet received, then outgoings made to gain that amount should be deductible when you are committed to paying them, even if you haven’t paid them yet (Anonymous 1997)”. The tax deduction needs to be claimed in the first four months respectively as even though the client might not have received his receipts of the revenues that he generated from his part time businesses, they still occurred. Therefore, the firm is just following the matching principle of accounting and according to it the client’s revenues that he incurred in the first four months as well as the tax deduction that he is liable to pay must both be recorded in the same period of time. This shall be done regardless of the time when the client received actual receipts for the income he generated from the first four months. The client however, must have taken into account the cash basis of accounting. The difference lies in the timing of when sales and purchases are recorded in your accounts (McCool 2017).
In the above mentioned case, the client is at fault while the firm is correct. However, it can be suggested to both the client as well as the firm to be clearer in their respective dealings for the future. While the firm must have assumed that the client should have been well aware of the matching principle of accounting, such was not the case. On the other hand, the client should have also been aware of the matching principle of accounting as he has been a management accountant and worked in the form for many years. There is always the possibility of confusion and ambiguity creating a gap and misunderstanding between two parties who feel they are right and the other one is wrong. Such situations can and must be avoided by coming to central grounds and negotiable terms acceptable to both parties.
In this particular case, however, as the firm happens to be correct, the client must admit failure to understand the tax deduction as per the matching principle of accounting. He must sign the documents and sent them back to the firm rendering his further approval.
Conclusion
Very often in real life scenarios such cases are seen where both parties stand true to their ground and feel they are correct while the other one is wrong. In this particular case, the client, who had previously worked in a firm as a management accountant had rented out a property in order to start a part time business in the form of coaching classes to students. The firm had created documents pertaining to the finances of the property the client had rented and the related taxes he was now viable to pay back. However, the client said that the firm had made a mistake in accounting for the tax deductions as there had been no revenues generated in the first four months of his renting the property. While the client claims that the firm is wrong in their decision to claim tax deductions, such is not the case. The firm had simply applied the matching principle of accounting which is based on the accrual system of accounting. According to this very principle, while creating the financial documents of any business firm, the revenues generated in a particular period of time and the expenses occurring related to that period must all be recorded in the financial documents of the same period. This removes any chances of confusion and ambiguity that might occur later on in the following months. In addition this, there is also a cause and effect relationship that gets established between the revenues generated and the related expenses incurred. In this case, the client had not received his revenue receipts for the first four months within the time frame. This led him to believe that he had not generated any revenues in the first four months. This was however, not the case. The client had actually generated revenues in the given time period. However, he had not received his receipts on time. Therefore, the firm was right in its decision to claim tax deductions related to the income generated in the first four months as this was in line with the matching principle of accounting.
References
Anonymous 1997, INCOME TAX ASSESSMENT ACT 1997 – SECT 6.5, viewed 2 november 2017, <https://www8.austlii.edu.au/cgi-bin/viewdoc/au/legis/cth/consol_act/itaa1997240/s6.5.html>.
Anonymous 1997, Taxation Ruling, viewed 1 november 2017, <https://law.ato.gov.au/atolaw/view.htm?Docid=TXR/TR977/NAT/ATO/00001>.
Bragg, S 2017, Accrual basis, viewed 1 november 2017, <https://www.accountingtools.com/articles/2017/5/7/accrual-basis>.
Bragg, S 2017, Cash basis, viewed 1 november 2017, <https://www.accountingtools.com/articles/2017/5/5/cash-basis>.
McCool, C 2017, Cash Basis Accounting vs. Accrual Accounting, viewed 2 november 2017, <https://bench.co/syllabus/accounting/cash-accounting-vs-accrual-accounting/>.
Nordmeyer, B 2017, Realization & Matching Principles of Accounting, viewed 31 october 2017, <https://bizfluent.com/info-12085882-realization-matching-principles-accounting.html>.
Potter, S 2014, Matching Principle, viewed 1 november 2017, <https://www.myaccountingcourse.com/accounting-principles/matching-principle>.
Ward, S 2016, Accrual Basis Accounting Versus Cash Basis Accounting, viewed 31 october 2017, <https://www.thebalance.com/accrual-basis-accounting-2947886>.
Watson, H 2017, The matching principle, viewed 1 november 2017, <https://www.accountingtools.com/articles/2017/5/14/the-matching-principle>.
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