What do period costs, product costs and revenue recognition all have in common? They are all components of the matching principle of GAAP. Not only that, they play an integral role in the proper bookkeeping of accrual accounting and the presentation of your financial statements.
Where Did the Matching Principle Come From?
The matching principle is part of Generally Accepted Accounting Principles (GAAP). The standards are developed and overseen by four main organizations. They are the Securities and Exchange Commission (SEC), the American Institute of Certified Public Accountants (AICPA), Finanal Accounting Standards Board (FASB) and Government Accounting Standards Board (GASB).
The SEC was created by the federal government as a means of establishing standards for financial reporting. Investors use financial statements to make important decisions; and after the Great Depression, people called for better oversight. The SEC partnered with the private sector, mainly FASB and the AICPA, to establish these standards. Now, with SEC oversight, the FASB is responsible for setting financial reporting standards and public companies are required by the SEC to follow them.
The matching principle is part of the set of standards belonging to GAAP. It follows accrual accounting and means that costs must be matched with revenue. Sound easy? Financial reported is a complicated animal.
Elements of the Matching Principle
The matching principle defines how accountants should recognize expenses. The basic theory is that expenses should follow revenue. In other words, we recognize the expenses on the financial statements when we show the revenue that those expenses produced. However, not all costs are easily matched to revenue. Thus, expenses fall into the two main categories of period and product costs.
Period costs are recorded on the financial statements when they are incurred. Officer salaries, rent for the headquarters building and other administrative expenses are examples of period costs. As you can tell, trying to match an officer's salary with units of product is not so easy. This is why such expenses are recognized on the financials when they occur.
Product costs can be associated with revenue. These include expenses such as direct material labor and factory overhead. Companies use an allocation method to match expenses to revenue.
For a better understanding of product and period costs read the article Product Costs vs. Period Costs.
Your Bottom Line
That's right, the matching principle effects your bottom line--well, at least on your financial statements. Product costs that are waiting to be matched to revenue sit on the balance sheet as an asset. The income statement depicts the period costs for the current period (think time frame here) and product costs that have been matched to revenue. Thus, the bottom line net profit or loss reported on your income statement is directly effected by the matching principle.
Compare an income statement that follows the matching principle to an income statement that does not (typically cash basis). You will see that the bottom line on a cash basis income statement is probably not very reflective of reality. What if, for example, all costs were incurred in the first half of the year and all revenue earned in the second half? You would see a semi-annual income statement for the first half of the year reflecting a loss. The second half of the year would reflect a profit. Thus, the matching principle is meant to help the users of financial statements (mainly investors) associate the numbers with reality.