LIFO Tax Treatment: Role of LIFO in the Tax Code

As we can see in this example, two transactions have been spread across a total of three years. This example is designed to illustrate the importance of the matching principle as, even though the materials were purchased in year 1, they weren’t sold until year 2. If expenses were reported as soon as they occurred, then company statements would be very inconsistent and profit figures would not be comparable.

This revenue was generated by the sale of goods costing 4.00 a unit and therefore the cost of goods sold is 32,000 (8,000 units x 4.00). Businesses primarily follow the matching principle to ensure consistency in financial statements. To illustrate the matching principle, let’s assume that a company’s sales are made entirely through sales representatives (reps) who earn a 10% commission. The commissions are paid on the 15th day of the month following the calendar month of the sales. For instance, if the company has $60,000 of sales in December, the company will pay commissions of $6,000 on January 15. While LIFO inventory accounting may be a less widely understood part of the tax code, it is a sound structural component and brings companies closer to deducting their real cost of goods sold (COGS).

Accrued expenses

According to the matching principle, the machine cost should be matched with the revenues it creates. Thus, the machine is depreciated over its 10-year useful life instead of being fully expensed in 2015. The cost of the asset or liability must be matched with the related revenue over its useful life. For example, if a company uses a building to generate revenue, the cost of the building must be recognized over the useful life of the building and matched with the related revenue. While accrual accounting is not a flawless system, the standardization of financial statements encourages more consistency than cash-based accounting. However, the matching principle matches expenses with the revenue they helped generate, as opposed to being recorded in the period the actual cash outflow was incurred.

The matching principle is one of the accounting principles that require, as its name, the matching between revenues and their related expenses. In contrast, cash-basis accounting would record the expense once the cash changes hands between the parties involved in the in quickbooks online transaction. Let’s say that the revenue for the month of June is 8,000, irrespective of the level of this revenue the matched rent expense for the period will be 750.

The matching principle allows distributing an asset and matching it over the course of its useful life in order to balance the cost over a period. Recognizing expenses at the wrong time may distort the financial statements greatly. The matching principle helps businesses avoid misstating profits for a period. But should be proportion to the economical use or in the ways how fixed assets contribute to sales revenue as well as production.

Matching and Costs which have no Future Benefit

One factor behind the decline of LIFO usage over time is the economy-wide shift away from goods and toward services.
For instance, the direct cost of a product is expensed on the income statement only if the product is sold and delivered to the customer.
This approach is essential for businesses extending credit to customers or receiving goods and services on credit.
Sales entries contain sales to customers matched with the inventory cost for the item sold; materials purchased for sale are matched with the spent cash; and wages paid are matched with the liability owed to employees.
The LIFO inventory method allows companies to deduct the cost of inventory at the price of the most recently acquired items and assumes that the last inventory purchased is the first to be sold.
The principle is based on the accrual accounting method, which records transactions when they occur, not when the cash is received or paid.

For both individuals and corporations, taxable income differs from—and is less than—gross income. In most places, financial transactions including both revenues and expenses must be recorded in the general ledger according to standard accounting guidelines. These guidelines can vary from place to place, but almost every jurisdiction enforces certain uniform rules that apply to all businesses and financial actors in the market. In the United States, the Financial Accounting Standards Board writes and issues accounting guidelines for companies to follow when conducting business.

Abolishing Taxes on Tips Would Be a Costly Mistake

Let me be more specific so that you can better understand the wages of the salesperson. One of the most straightforward examples of understanding the matching principle is the concept of depreciation. The matching principle stabilizes the financial performance of companies to prevent sudden increases (or decreases) in profitability which can often be misleading without understanding the full context. The cumulative benefits of LIFO relative to FIFO are known as the LIFO reserve. My Accounting Course is a world-class educational resource developed by experts to simplify accounting, finance, & investment analysis topics, so students and professionals can learn and propel their careers. Get instant access to video lessons taught by experienced investment bankers.

Matching and Expenses Directly Associated with Revenue

The revenue would mostly be a one-time windfall for the first few years after LIFO repeal is implemented. In the long term, LIFO repeal raises minimal revenue, with the economic costs of LIFO further diminishing tax collections. An accountant will recognize both expenses and revenue and then correlate even though cash flow runs inconsistently. In general, the Matching principle helps both accountants recognize the accounting understanding s corporations transactions in some uncertain situation and users of financial transactions for using the entity’s financial information.

What is the Matching Principle of Accounting?

Explore how the matching principle shapes accurate financial reporting and its crucial role in modern accrual accounting practices.
The reduction of the inventories corresponding to revenues is called the cost of goods sold.
The business uses the straight line depreciation method and calculates the annual depreciation expense as follows.
It purchases a large appliance from wholesalers for $5,000 and resells it to a local restaurant for $8,000.
For example, one act of retroactive taxation may suggest the potential for future acts of retroactive taxation, which changes investment incentives in the present.
The principle is used as accountants prepare and post journal entries; each entry must include a debit and credit that balances the entry prior to posting in the general ledger.

The matching principle is quite important to users of the financial statements, especially to understand the nature of expenses recorded in the entity’s financial statements. The salary expenses are the cost of services the company renders from its staff. The services rendered in which months and salary expenses should be recorded on those months. For example, based on a cash basis, the revenue amount of $70,000 is recognized only when the cash is the receipt.

Matching principle is especially important in the concept of accrual accounting. Matching principle states that business should match related revenues and expenses in the same period. They do this in order to link the absorption costing and variable costing explained costs of an asset or revenue to its benefits.

The alternative is reporting the expense in December, when they incurred the expense. The image below summarizes how the matching principle is part of the accrual basis of accounting. A business selects a time period for its accounting (year, quarter, month etc) and uses the revenue recognition principle to determine the revenue for that period. Based on this time period and revenue recognized the matching principle is used to determine the expenses to be included. The matching principle or matching concept is one of the fundamental concepts used in accrual basis accounting.

If the costs are expected to have no future benefit beyond the current accounting period then the full amount should be immediately recognized as an expense. Expenses of this type include items such as the production costs relating to faulty goods which cannot be sold, research costs and general expenses. The matching principle, while essential, is often misunderstood or misapplied, leading to potential distortions in financial reporting.

Examples of the Matching Principle

Not following the rules or failing to apply the rules properly can lead to sanctions and fines. Proper matching can help accountants realize whether there’s a discrepancy before records are filed in any official way. This revenue was generated by the activities of the sales agents and the matching principle in accounting requires the matching of the sales commission expense to this revenue. Cash flow statements, though focused on cash transactions, are indirectly influenced by the matching principle. Timing differences between cash transactions and the recognition of revenues and expenses can create discrepancies between net income and cash flow from operating activities. Reconciliation processes explain these differences to stakeholders, offering insights into the company’s liquidity and cash management practices.