AC4304 Financial Reporting Theory Week 11 Accurate Matching is NOT Possible Li Cheuk Fung, Henry Lo Michael Chitung Mak Chi Keung, Mike

Agenda What is matching principle?? Importance of matching principle Definition of accurate matching 3 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 period To 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 departments 3. By projects of operations (project by project) 4. Classes of costs 5. 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. ExpensesRevenue CauseEffect

An example of Cause and Effect Effect: Revenue Financial year Sales commissionRevenue Cause: Salesmans effort Matching commission & revenue in P&L Year end

1 st Argument against Cause and Effect RATIONAL FEASIBLE

1 st 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

1 st 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

1 st 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

1 st Argument against Cause and Effect The 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

1 st Argument against Cause and Effect Therefore: Matching can only be based on an assumption. No directly cause and effect relationship can be created

2 nd 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.

2 nd 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 $ 15,000 MATCHING

2 nd 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 balance FIFO, 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 cost with 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 UnambiguityDefensibility

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 accurate matching can be get by cost allocation

So… Allocation methods commonly used are too simplified It is unjustified to allocate cost sometimes, and It 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 used E.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. Matching If conservatism wins, violate matching So, company cannot match expenses with revenue

Conclusion Cause and Effect Ideal way to match expenses with revenue Rational but not feasible Allocation of Costs A cost effective way to monitor companys performance Inaccurate matching because estimation and subjectivity involved Immediate Recognition Conservatism vs. Matching