Download Slides 1-4 (1m:49s) Welcome to Introduction to Accounting

Slides 1-4 (1m:49s)
Welcome to Introduction to Accounting Preparing for a User’s Perspective
Accrual Accounting: Revenue Recognition and the Matching Principle
Slide 2
Lenders and investors rely heavily on a company’s reported Net Income to make lending and
investing decisions. So it is important that management ensures that the reported Net Income is
fairly stated.
Reported Net Income will be misstated IF either Revenues or Expenses:
1) are reported at the wrong amounts $ or
2) are reported in the wrong periods.
Slide 3
Accrual accounting helps management avoid Net Income misstatements of amount $ and
timing. It is comprised of two principles:
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
Revenue recognition principle
Matching principle
The revenue recognition principle helps ensure that management reports REVENUES at the
proper amount and in the correct accounting period.
The matching principle helps management record EXPENSES at the proper amount and in the
proper accounting period.
Slide 4
Revenue recognition principle. You should recognize revenues in the accounting period when
they become realized or realizable and are earned. For revenues to be realized or realizable and
earned a few things need to happen:
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
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you need to deliver a good or service
you should receive cash or claims to cash or assets that can be readily converted to cash
the earnings process needs to be substantially complete or you need to deliver the
promised goods or services
Matching principle. You should recognize expenses in the same accounting period as the
revenues that they helped generate. In other words you match them. If you have revenues, think
about the expenses that helped you to generate the revenues and report both the revenues and
expenses in the same accounting period.
Slides 5-8 (3m:39s)
There are three common revenue recognition situations.
1) Cash is received at the SAME time as the revenue is recognized.
This one is easy because there won’t be any adjustments needed because both the cash flow and
the earnings process happen in the same accounting period. This is the one you like to see but
life isn’t always that easy.
2) Cash is received BEFORE the revenue is recognized.
In this case, you will have to defer the recognition of revenue until it is earned, so even though
you received the cash in X1, you cannot report the revenue on the income statement until X2
when you’ve earned it. Adjustments will be needed to deal with this deferred revenue at the end
of X1.
3) Cash is received AFTER the revenue is recognized.
In this case you will have what is called an accrued revenue because you will record the revenue
in this year, but the cash will be received in the following year. Adjustments will be needed.
Revenue recognition is all about the amount and timing of revenues.
Slide 6
Let’s go through a few examples.
1) Cash is received at the SAME time as the revenue is recognized.
Background: Jones Co. is an independent sales agent for Bob Co. Jones Co. is paid a 5%
commission on all sales it helps Bob Bo. Make.
So we are going to do the accounting for Jones Co.
Example: In 20X2, Jones Co. received a $100 sales commission from Bob Co. related to a sale
made in 20X2.
Since Jones Co. earned it, it recognized the revenue [in 20X2] and since it received the cash, it
recorded the cash.
Both of these happened in the same accounting period and this is the simple situation.
No adjusting entries and no other accounts are needed.
Slide 7
2) Cash is received BEFORE the revenue is recognized.
Example: In 20X1 Jones Co. received $100 cash in advance from Bob Co. for sales
commissions he expected to earn in 20X2.
As you can see, the cash is received, and since he can’t record the revenue, we’ve got to figure
out what the credit in this journal entry is going to be to balance out the receipt of cash. In the
following year, he earns the revenue and we’ve got to ask ourselves, “What is the debit to
balance out the earnings process?” because the cash was received in the prior year.
In the first year, since you [Jones] received cash in advance of doing the work, he has a liability,
so he has unearned revenues. This is an increase in liabilities.
In the following year, he finally earns the revenue he has to reduce the liability because now it’s
earned. Cash is not recorded in 20X2 because it was already recorded back in 20X1.
This is not so easy. The unearned revenue account is used to defer revenue recognition to 20X2
when the revenue is recognized.
Slide 8
3) Cash is received after the revenue is recognized.
Example: In 20X2 Jones Co. earned $100 in sales commissions from Bob Co., but Jones Co.
didn’t receive the commission payment until 20X3.
In this case, Jones Co. records the revenue because he earned it, but since he didn’t receive cash,
he needs a debit here to balance out this entry. That debit is called accounts receivable.
When he finally receives the payment, he no longer has the receivable so he has to remove the
receivable by crediting it.
This one is not so easy. The accounts receivable account is used to accrue revenue until 20X3
when the cash is finally received.
Slide 9-12 (3m:15s)
Three common matching principle situations.
1) Cash is paid at the SAME time as the benefit received. This one is easy. There are no
adjustments needed.
2) Cash is paid BEFORE the benefit is received. In this case, you will have to defer the
expense until the benefit is received. Yes, adjustments will be needed.
3) Cash is paid AFTER the benefit is received. In this case, you will have to accrue an
expense in 20X2, creating a liability which is finally paid off in 20X3. Yes, adjustments will be
needed.
Matching Principle: Deals with the amount and timing of expenses.
Slide 10
1) Cash is paid at the SAME time as the benefit is received.
In this example, we are going to do the accounting for Bob Co.
Example: In 20X2, Bob Co. made a $2,000 cash sale and incurred AND paid Jones Co. a $100
commission.
Here you can see that the selling expenses are properly matched to the sales revenue in the same
year and thereby we complied with the matching principle.
This one is easy. No adjusting entries and no other accounts are needed. It’s all self-contained
in the same year.
Slide 11
2) Cash is paid BEFORE the benefit is received.
Example: In 20X1 Bob Co. paid Jones Co. $100 cash in advance for an anticipated sales
commission that it expects to incur in 20X2.
In this case, since Bob Co. has not received the benefit yet, he effectively has prepaid for the
expense. So this [prepaid expense] is an asset. He gave up one asset, cash of $100, in exchange
for another asset, prepaid expense $100.
In 20X2, Bob Co. made a $2,000 cash sale and incurred the $100 commission to Jones Co. as
expected.
Since he already paid for it [the commission] he’s not going to record a credit to cash in 20X2,
but rather, he will eliminate the asset called prepaid expense $100.
As you can see, the selling expenses are properly matched to sales revenue in the same year even
though the cash flow occurred back in 20X1.
Not so easy. Prepaid expense account is used to “defer” the expense recognition until 20X2
when the expense IS recognized.
Slide 12
3) Cash is paid AFTER the benefit is received.
Example: In 20X2, Bob Co. made a $2,000 cash sale and incurred a $100 sales commission to
Jones Co. Bob Co. has decided not to pay the commission until 20X3.
Therefore, he has to set up a liability to pay the sales commission.
Liability accounts payable goes up $100.
The cash actually is paid in 20X3 and thereby reduces the liability. No selling expense is
recorded in 20X3 because it matched the revenues back in 20X2. All we are doing is eliminating
the liability account.
In compliance with the matching principle, you can see that selling expenses are properly
matched to sales revenues in 20X2.
This one is not so easy. Accounts payable account is used to “accrue” expenses into the current
accounting period allowing later payment.
Slides 13-15 (0m:53s)
Even though many transactions do not affect revenues (revenue recognition principle) or
expenses (matching principle) they still must be recorded.
For example, if you receive a $1 asset by giving up a $1 asset, assets will increase and assets will
decrease, net income is not affected.
If you receive a $1 asset by increasing a $1 liability, assets increase, liabilities increase, net
income is not affected.
If you receive a $1 asset by issuing $1 of capital stock, assets will increase and equity will
increase, net income is not affected.
If you pay a dividend by giving up a $1 asset, equity will decrease and assets will decrease, but
net income is not affected.
Slide 14
I hope this topic has helped you get a quick view of accrual accounting, particularly how we deal
with the revenue recognition and the matching principle.
Slide 15
Good luck on the quiz.