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Matching principle is a cornerstone of accrual accounting together with revenue recognition. They both determine the point, at which expenses and revenues are recognized. According to the principle, expenses are recognized when they are (1) incurred and (2) offset against recognized revenues, which were generated from those expenses (or related on the cause-and-effect basis), no matter when cash is paid out. In contrast, cash accounting records expenses, when cash is paid out no matter when obligations are incurred and regardless of revenues.
If no cause-and-effect relationship exists (e.g. no sale took place), costs are recognized as expenses in the accounting period when they used up or have expired (e.g. of spoiled, dated, substandard goods or not demended services). Prepaid expenses (prepayments) are not recognized as expenses, but as assets until one of the qualifying conditions is met resulting in a recognition as expenses. Lastly, if no connection with revenues can be established, costs are recognized immediately as expenses (e.g. general administrative, selling and research and development costs).
For instance, worker wages or subcontractor fees paid out or promised are not recognized as expenses until the actual products are sold. When the products are sold, such obligations are recognized as cost of goods sold (expenses).
Matching principle allows better evaluation of actual profitability and performance (shows how much was spent to earn revenue), and reduces noise from timing mismatch between when costs are incurred and when revenue is realized.
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Examples
Depreciation - exemplifying matching principle - spreads the cost of purchasing a fixed asset over the period, in which it is expected to generate revenue.
Product costs are costs which add value to inventory. These costs are capitalized (added to assets), and only later - according to matching principle - are moved to expenses as cost of goods sold.
Period costs are recognized immediately as expenses, such as general administrative and selling costs, and do NOT exemplify matching principle.
Accruals
Accruals are used to enable management the matching principle to be managed according to matching principle. An example is that of a supplier supplying you goods in one month, but not billing you until the following month. If the goods are sold in the month they were supplied there would be no matching costs i.e. no supplier invoice cost to match the sales value and calculate a profit on the goods sold. If there is no cost then you would make 100% profit in the month you sold the goods and then incur a cost in the next month where there is no matching sale.
Prepayments
Prepayments are used to enable management of costs not recognized as expenses according to matching principle. An example are these of insurance. Insurance costs are usually paid out on annual basis. So, if accounting periods are monthly, then only 1/12th of annual insurance costs is to be recognized as expense in each month rather than all in the month, in which such costs were billed. The not recognized portion of such costs remains as an asset within prepayments.
Similarly, costs that have been paid out for goods and services not received by the end of an accounting period are recorded as prepayments. These costs will not be recognized as expenses in Income Statement (Profit and Loss or P&L). When the goods or services are received, then such costs are recognized as expenses in P&L and deducted from prepayments (assets) on balance sheets.
Depreciation
Depreciation is used to apportion the cost of the asset over its expected lifespan according to matching principle. If you bought a machine for $100,000 and it has a life span of 10 years and it can produce the same amount of goods each year, you would match $10,000 of the cost of the machine to each year rather than charge $100,000 in the first year and nothing in the next 9 years. So when you sell items in each year you apportion a cost of the machine against the sales in that year. This matches costs to sales.
