AC4304Financial Reporting Theory

Week 11Accurate Matching is NOT Possible

Li Cheuk Fung, Henry 50190712

Lo Michael Chitung 50190512

Mak Chi Keung, Mike 50193890

Agenda

What is matching principle??Importance of matching principleDefinition of accurate matching3 basic principles of matching & Arguments Cause and Effect Allocation of Costs Immediate Recognition

Conclusion

Definition of Matching

Procedure: Determine revenue Match against expenses (effort to

generate that revenue)

Involves combined recognition of revenues and expenses that result directly or jointly from the same transaction or other events

Importance of Matching

Guide accountants to decide which costs should remain unexpired or expensed to match against revenue generated for the periodTo calculate a ‘true’ profit to reflect actual performance of a company

Accurate Matching

Expenses can be matched exactly with the revenue generated and/or,

Future economic benefits (FEB) of each transaction can be matched with particular expenses incurred for that transaction

Accuracy of matching basis

1. On a basis of items of products (product by product)

2. By departments3. By projects of operations (project

by project)4. Classes of costs5. Time period (mostly used by

accountant)

Most accurate

Less accurate

Therefore…

3 Basic Principles of Matching

-Cause and Effect-Allocation of Costs-Immediate Recognition

Matching by Cause and effect

Meaning of Matching by Cause and Effect

Certain goods and services used up must have aided in the creation of the revenue for the period.

Expenses Revenue

Cause Effect

An example of Cause and Effect

Effect: Revenue

Financial year

Sales commission Revenue

Cause: Salesman’s effort

Matching commission & revenue in P&L

Year end

1st Argument against Cause and Effect

RATIONAL

FEASIBLE

1st Argument against Cause and Effect

Accurate matching should be: Direct cost association with relevant revenue in terms of units of output.

Costs incurred in outputs

Revenue (attributable to the costs) generated from those outputs

MATCHING

Profits

1st Argument against Cause and Effect

However, it is not possible! Not all costs are in a discernible manner. Revenue directly attributable to the

expense is not observable

Depreciation of assets incurred in units of outputs

Revenue from outputs (attributable to the depreciation)

MATCHING

Profits

1st Arguments against Cause and Effect

In general practice: match costs and revenue to the

related period of time.

Costs incurred in a period

Revenue generate in the period

MATCHING

Profits

1st Argument against Cause and EffectThe assumption is:

Costs assigned to a given time period as expenses must therefore have helped to generate the revenue for that period.

Cost incurred in 2001

MUST GENERATE

Revenue in 2001

1st Argument against Cause and Effect

Therefore: Matching can only be based on an

assumption. No directly cause and effect

relationship can be created

2nd Argument against the Cause and Effect Method

There is no evidence to prove: certain percentage of expenses

generate the same percentage of revenue.

Matching by cause and effect also implies: Certain amount of revenue can be

attributable to a certain amount of expenses.

2nd Argument against the Cause and Effect Method

E.g. we cannot prove the proportion of total expenses of a project did really generate that proportion revenue of the project.

Total Revenue

$ 100,000

Total Expense

$ 60,000

$ 25,000 Salaries & Wages

$ 15,000MATCHING

2nd Argument against the Cause and Effect Method

As a result, no accurate amount of revenue can be matched precisely with the relevant expenses.

Allocation of Costs

Matching by Allocation of Costs??

Matching process begins by associating expenses to segments of time. When this is accomplished, the amount of expenses is assumed to correlate with the revenues for that period.Therefore match incurred expense with the economic benefit received by the company in that period.

Method used currently

Straight Line, Reducing balanceFIFO, LIFO, Weighted Average

Does allocation of cost accurately match expense with future economic benefit generated?

Which one is more accurate?

Matching costs with revenue basing on: Individual transaction, or Time Period

Matching cost with individual transaction is more accurate, BUT practically

it is easier to match costwith time period!

Does currently used allocation method too simplified for the purpose of accurate matching?

E.g. Allocation of depreciation

Assumptions need to made Time period Rate of depreciation Depreciation method

Why assumptions become unrealistic Subjective to government regulation Costly to do accurate measurement Unable to receive timely information Lack of information

Does accounting justified to use allocation approach?

When accounting is justified to use allocation approach?

3 criteria need to satisfied Additivity

When the allocating amount is added together, the total is the same as before the allocation.

Unambiguity A clear-cut choice of the method should

be made Defensibility

The selected allocation method should be conclusive and can be defend against other possible alternative method

When accounting is justified to use allocation approach?

According to Arthur L. Thomas

Additivity

To use allocation approach

Unambiguity Defensibility

The reasons are

Available of variety of methods

Each of methods can defend with each other

No conclusive method to choose which allocation methods preference than others

If it is unjustified to allocate cost?

It is also unjustified to say accuratematching can be get by cost allocation

So…

Allocation methods commonly used are too simplifiedIt is unjustified to allocate cost sometimes, andIt is inaccurate to match expense with revenue by allocation of cost

Immediate Recognition

If expenses are not covered by first 2 methods, it will be usedE.g. Advertising expense

It may have long-lasting benefits, but it is difficult to determine them

It is difficult to measure exact F.E.B. Customers saw an ad. 2 years ago

and buy goods now (ad. Cost recognized 2 years ago)

Argument

In HKSSAP, advertising expense cannot be capitalized (∵ FEB is uncertain)Conservatism vs. MatchingIf conservatism wins, violate matchingSo, company cannot match expenses with revenue

ConclusionCause and Effect Ideal way to match expenses with

revenue Rational but not feasible

Allocation of Costs A cost effective way to monitor

company’s performance Inaccurate matching because

estimation and subjectivity involved

Immediate Recognition Conservatism vs. Matching