Accounting for Revenue and Expenses

1. TOPIC 7 Accounting for Revenue and Expenses

2. What is “Reality” in Business? • A firm performs the following functions: • .. it operates to generate revenues, • .. it invests resources to enable operations, • .. it finances its operations and investments with both internal and external sources, and • .. it makes decisions.

3. Measurement of Reality • An accounting system needs to record the reality of each business event. • Unfortunately, there is often a distortion between the reality and the measurement of reality. • No matter how accurately the measurement of reality reflects reality, it is not that reality.

4. Periodic Measurement Problems • Many differences between “reality” and the “measurement of reality” stem from the accountants need to measure activities for a specific period (month, quarter, year, etc.). • If we didn’t apply this assumption of “periodicity,” then we would not be able to prepare monthly financial statements or annual reports.

5. Periodic Measurement Problems • It is the “cut-off” at the end of the period that causes those problems. Accountants are basically required to take the entire life-span of a business and chop it up into little chunks.

6. Periodicity Example • Assume you are a house painter. On Dec. 20, you agree to paint a house for a total fee of $3,000. You begin the work on December 28 and you finish the job on January 6. The customer pays you the full amount on Jan. 7. • When should the $3,000 be shown as a revenue? (Let’s assume that you were about 1/3 finished with the job as of December 31.)

7. Revenue and Expense Recognition • When accountants say that a revenue or expense has been recognized, they mean that: • the revenue or expense has been recordedin the accounting records (i.e., “the books”), and • that it is beingreportedon the financial statements of the business.

8. Revenue and Expense Recognition • There is no perfect way to determine when recognition should take place, thus we have to follow certain accounting rules and conventions. • There are two basic approaches to determining when to recognize revenues and expenses. These are two different ways to measure reality.

9. Two Bases of Economic Measurement • Cash Basis: The easy way! When cash comes in, it’s a revenue; when cash goes out, it’s an expense. (Some exceptions apply!) • Accrual Basis: Recognize revenues when “earned” and expenses when “incurred.” The timing of the related cash inflow or outflow is irrelevant.

10. Cash Basis Financial Statements • To prepare financial statements using the cash basis of accounting: • cash inflows are considered revenues (except from owners and creditors), and • cash outflows are considered expenses (except distributions to owners and repayments of principal to creditors).

11. Cash Basis Example • Assume the following facts: • You invested $25,000 to start a proprietorship, • During your first month of business, you had: • sales of inventory to customers totaling $20,000 (NOTE: $5,000 of the sales were credit sales and were not collected in the first month. • purchases of inventory totaling $20,000 for which you paid cash to the supplier (one-half is still on hand) , (continued on next slide)

12. Cash Basis Example • To continue: In your first month you also: • had employees that earned a total of $5,000. Because payday doesn’t coincide with the end of the month, you have only paid them $3,000 of the amount earned. • paid for a one-year insurance premium of $2,400. • incurred other operating expenses (utilities, etc.) totaling $2,000 which were all paid with cash. • purchased equipment and fixtures at a cost of $12,000. You believe these assets will last 10 years. • borrowed $5,000 from the bank on the last day of the month because you were low on cash.

13. Cash Basis Analysis • Analyzing this data according to the cash basis of accounting: • you had revenues for the cash collected from customers, but not for the cash you invested in the business, and not for the cash from the bank loan. • you had expenses equal to the cash paid for all of the different purchases, the wages paid, and the other operating costs.

14. Cash Basis Income Statement

15. Cash BasisStatement of Capital

16. Cash Basis Balance Sheet

17. Accrual BasisFinancial Statements • The accrual basis of accounting does not focus on the timing of the cash flows, but rather on the timing of the event that results in a revenue or expense. • Definition of accrue: To come into being as a legally enforceable claim. • The key is to determine when to recognize revenues and expenses for a business.

18. Revenue recognition • Sale of goods • Rendering of services

19. Revenue recognition • Goods includes goods produced by the entity for the purpose of sale and goods purchased for resale, such as merchandise purchased by a retailer or land and other property held for resale..

20. Recognition criteria: Sale of goods • Revenue from the sale of goods shall be recognized when all the following conditions have been satisfied:(a) the entity has transferred to the buyer the significant risks and rewards of ownership of the goods;(b) the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;(c) the amount of revenue can be measured reliably;(d) it is probable that the economic benefits associated with the transaction will flow to the entity; and(e) the costs incurred or to be incurred in respect of the transaction can be measured reliably.

21. Revenue recognition:Rendering of services • When the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction shall be recognized by reference to the stage of completion of the transaction at the balance sheet date. The outcome of a transaction can be estimated reliably when all the following conditions are satisfied:

22. Revenue recognition:Rendering of services (cont..) • (a) the amount of revenue can be measured reliably;(b) it is probable that the economic benefits associated with the transaction will flow to the entity;(c) the stage of completion of the transaction at the balance sheet date can be measured reliably; and(d) the costs incurred for the transaction and the costs to complete the transaction can be measured reliably. *

23. Revenue Recognition • Under the accrual basis, revenue should berecognizedwhen it is “earned.” You have earned revenue when you have a legally enforceable claim to receive something of value (usually cash) for the revenue. • Cash may be received at the same time that the revenue is earned, afterthe revenue is earned, or before the revenue is earned.

24. Revenue Recognition • There are three questions that help determine when revenue should be recognized: • Has title to the “goods” been transferred to the customer? • Has an exchange of “goods” (or services) taken place? • Is the earnings process virtually complete? (Has the business done all they need to do?)

25. Discussion Questions • Recall your $3,000 house painting job from a previous slide. When should you recognize the revenue from this job if you use the: • cash basis of accounting? • accrual basis of accounting?

26. Expense Recognition • Under accrual accounting, an expense should be recognized when you receive the benefit from the expense. • Cash might be paid at the time the expense is incurred, • Cash might be paid after incurring the expense, • Cash might be paid before the expense is incurred.

27. Discussion Questions • Think about the following three situations: • 1. You pay a one-year insurance premium. • 2. You buy a scratch-off lottery ticket. • 3. You pay your utility bill ten days after it arrives in the mail. • If you accounted for your life using the accrual basis, does the timing of the cash outflow coincide with the recognition of expense? (Before, same time, or after?)

28. Concept of Matching • The accounting principle that supports the accrual approach to recording transactions is known as the matching principle. • Revenues that are recognized for a specific time period should be matched with the expenses that were required (or used) in order to generate those revenues.

29. Concept of Matching • There may be a direct cause and effect between expenses and revenues. In this case, it is easy to properly apply the matching principle.

30. Concept of Matching • Example of cause and effect: Malaysian Mail Order Company (MMCO) received a phone order from a customer for a $100 item. M.M.O.C pays a $5 shipping charge on the order. • The shipping expense is directly caused by the sale, and the expense should be recorded in the same time period as the sale, thus matching is achieved.

31. Concept of Matching • There might NOT be a direct cause and effect between expenses and revenues. Properly applying the matching principle is more difficult in this situation. • Solution #1: Allocation of expense to the time periods that are benefited. • Example: two years’ rent paid in advance should be split between the two years.

32. Concept of Matching • If solution #1 is not reasonable, then use: • Solution #2: Immediate recognition of expense. • Use this approach if: • a) there is no identifiable future benefit, or • b) if the future benefit cannot be reasonably measured.

33. Differences Using Both Methods: Example: Below is a Salma Enterprise for a month of June 2005. RM Sales (70% on credit) 60,000 Advertising expenses (cash) 1,000 Rent expense (cash) 1,500 Depreciation Expense 1,200 Salary expense (unpaid) 18,000 Collection from customer 8,000 (from May credit sales) Differentiate the profit by using both basis.

34. Accrual Basis: Sales (total) 60,000 Less: Advertising 1,000 Depreciation 1,200 Rent 1,500 Salary 18,000 (21,700) Net Profit 38,300 Cash Basis: Sales:Cash Collection 8,000 Cash Sales 18,000 Less: Advertising 1,000 Rent 1,500 (2,500) Net Profit 23,500

35. Example of Immediate Recognition • Many companies spend huge amounts of money for “research and development.” There is little question that these expenditures lead to future benefits for the company. However, how do you estimate the dollar amounts of those benefits? • Since we can’t reliably measure the future benefits, R&D costs are expensed immediately.

36. Example of Cost Allocation • One of the best examples of solution #1 (allocating the cost over time) is the depreciation of a long-term asset. Assume that your company buys a delivery truck that you plan to use for the next four years. • The purchase cost of the truck should not be an expense when you buy it, but should be “spread out” over the next four years.

37. DepreciationISa procedure that allocates cost over more than one time period. Definition of depreciation: a systematic and rational allocation of the cost of a long-lived item from asset to expense. Depreciation

38. Depreciation IS NOT an attempt to measure the “fair market value” of an asset that is owned by a business. It IS NOT necessarily a way of determining how much of an asset’s value has been “used up.” Depreciation

39. Depreciation • To calculate the annual depreciation for an asset, we need to make two estimates: • (1) the useful life of the asset (not necessarily the same as the total life of the asset), and • (2) the residual value of the asset (i.e., what it will be worth at the end of the useful life).

40. Depreciation • The depreciable base is equal to the original cost minus the disposal value. • Example: Your company buys a computer for $7,000. Estimated useful life is 4 years and estimated disposal value is $1,000. • The depreciable base is $6,000, and you would recognize depreciation expense of $1,500 per year ($6,000 / 4 years).

41. Depreciation • Over the 4 years, most of the asset value is converted to expense. The cost is spread over the periods benefited.

42. Discussion Questions • How would the cost of the computer system be treated if you were using the cash basis? • Look again at the depreciation schedule for the computer. Does the $4,000 book value at the end of 1999 represent what we could sell the system for at that time?

43. Adjustments • At the end of each accounting period, certain adjustments must be made prior to preparing the financial statements. • These adjustments are necessary to ensure that all items of revenue and expense have been properly recognized during the period. • There are two basic types of adjustments: Accruals andPrepayments.

44. Accruals • An accrual adjustment would be necessary to recognize items that have not yet been recorded in the accounting records. • An accrued revenue would be a revenue that has been earned but not yet recorded. • An accrued expense would be an expense that has been incurred, but not yet recorded.

45. Example of Accrued Revenue • Remember the house painting example. You didn’t get paid until the job was completed. However, if you were preparing an accrual basis income statement at the end of December, you would need to show $1,000 (1/3 of the total) of accrued painting revenue for the amount of work that you have completed so far.

46. Example of Accrued Expense • To start your house painting business, you took out a three-year small business loan at the local bank. You will pay back the principal and all of the interest at the end of three years. If the interest is $1,000 per year, you would have an accrued interest expense of $1,000 each year, even though you are not going to pay until the third year.

47. Prepayments • A deferral is an item that has been recorded, but that should not be recognized as a revenue or expense until a later period. • A prepaid revenue would occur when cash is received in advance, but not yet earned. • A prepaid expense would occur when cash has been paid in advance, but the expense has not been incurred (i.e., a prepayment).

48. Accrual Basis Financial Statements • Financial statements that are prepared on the accrual basis will be the result of the proper application of all of the revenue and expense recognition rules, and the proper adjustments at the end of the period for all of the accruals and deferrals. • Let’s use the “My Proprietorship” example and make financials on the accrual basis.

49. Accrual BasisIncome Statement

50. Discussion Questions • Consider the following statement as it relates to the accrual basis of economic measurement: • “Net income is an opinion, cash is a fact.” • What do you think it means?