Fundamentals of Accountancy, Business and Management 2
REVENUE RECOGNITION PRINCIPLE
The revenue recognition principle states that, under the
accrual basis of accounting, you should only record revenue when
an entity has substantially completed a revenue generation
process; thus, you record revenue when it has been earned. For
example, a snow plowing service completes the plowing of a
company's parking lot for its standard fee of $100. It can recognize
the revenue immediately upon completion of the plowing, even if it
does not expect payment from the customer for several weeks.
A variation on the example is when the same snow plowing service
is paid $1,000 in advance to plow a customer's parking lot over a
four-month period. In this case, the service should recognize an
increment of the advance payment in each of the four months
covered by the agreement, to reflect the pace at which it is earning
the payment.
If there is doubt in regard to whether payment will be received
from a customer, then the seller should recognize an allowance for
doubtful accounts in the amount by which it is expected that the
customer will renege on its payment. If there is substantial doubt
that any payment will be received, then the company should not
recognize any revenue until a payment is received.
Also under the accrual basis of accounting, if an entity receives
payment in advance from a customer, then the entity records this
payment as a liability, not as revenue. Only after it has completed
all work under the arrangement with the customer can it recognize
the payment as revenue.
Under the cash basis of accounting, you should record revenue
when a cash payment has been received. For example, using the
same scenario as just noted, the snow plowing service will not
recognize revenue until it has received payment from its customer,
even though this may be a number of weeks after the plowing
service completes all work.
ACCRUAL BASIS ACCOUNTING
Under the accrual basis of accounting, revenues are
reported on the income statement when they are earned. (Under
the cash basis of accounting, revenues are reported on the income
statement when the cash is received.) Under the accrual basis of
accounting, expenses are matched with the related revenues and/or
are reported when the expense occurs, not when the cash is paid.
The result of accrual accounting is an income statement that better
measures the profitability of a company during a specific time period.
EXAMPLE: If I begin an accounting service in December and provide
$10,000 of accounting services in December, but don't receive any of
the money from the clients until January, there will be a difference in
the income statements for December and January under
the accrual and cash bases of accounting. Under the accrual basis,
my income statements will show $10,000 of revenues in December
and none of those services will be reported as revenues in January.
Under the cash basis, my December income statement will show no
revenues. Instead, the December services will be reported as January
revenues under the cash method.
There will be a difference on the balance sheet, too. Under the
accrual basis, the December balance sheet will report accounts
receivable of $10,000 and the estimated true profit will be added
to owner's equity or retained earnings. Under the cash basis, the
$10,000 of accounts receivable will not be reported as an asset, and
the true profit will not be included in owner's equity or retained
earnings.
To illustrate a difference in expenses, we will assume that the heat
and light expense that I used in my accounting service is metered by
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the utility on the last day of the month. The utilities that I used in
December will appear on a bill that I receive in January and will pay
on February 1. Under the accrual basis of accounting, the utilities that
I used in December will be estimated and will be reported as an
expense and a liability on the December financial statements. Under
the cash basis of accounting, the utilities used in December will be
recorded as an expense on February 1, when the utility bills are paid.
For financial statements prepared in accordance with generally
accepted accounting principles, the accrual method is required
because of the matching principle.
REVENUE
is the amount of money that a company actually receives
during a specific period, including discounts and deductions for
returned merchandise. It is the "top line" or "gross income" figure from
which costs are subtracted to determine net income.
Revenue is calculated by multiplying the price at which goods or
services are sold by the number of units or amount sold.
Revenue is also known as "REVs."
Revenue is the amount of money that is brought into a company by its
business activities. Revenue is also known as sales, as in the price-
to-sales ratio, an alternative to the price-to-earnings ratio that uses
revenue in the denominator.
There are different ways of calculating revenue, depending on the
accounting method a business employs. Accrual accounting will
include sales made on credit as revenue, as long as the goods or
services have been delivered to the customer. It is therefore
necessary to check the cash flow statement to assess how efficiently
a company collects the money it is owed. Cash accounting, on the
other hand, will only count sales as revenue if the payment has been
received. When cash is paid to a company, this is known as a
"receipt" to distinguish it from revenue. It is possible to have receipts
without revenue, if the customer paid in advance for a service that has
not been rendered or goods that have not been delivered.
Revenue is known as the "top line" because it is displayed first on a
company's income statement. Expenses are then deducted from
revenue in order to obtain net income, or profit – the "bottom line."
A company's revenue may be subdivided according to the divisions
that generate it. For example, a recreational vehicles department
might have a financing division, which could be as a separate source
of revenue. Revenue can also be divided into "operating revenue," or
sales from a company's core business, and "non-operating revenue,"
which derives from other, secondary sources. As these non-operating
revenue sources are often not predictable or recurring, they can be
referred to as one-time events or gains. For example, proceeds from
the sale of an asset, a windfall from investments or money awarded
through litigation would be considered non-operating revenue.
Investors will often consider a company's revenue and net income
separately to determine the health of a business. It is possible for net
income to grow while revenue remains stagnant, as a result of cost-
cutting; such a situation does not bode well for a company's long-term
growth. When public companies report quarterly earnings, the two
figures that receive the most attention are typically revenue and
earnings per share ("earnings" being equivalent to net income).
Subsequent price movement in stocks generally correlates to whether
a company beat or missed analysts' revenue and earnings per share
expectations.
In the case of government, revenue is the money received from
taxation, fees, fines, inter-governmental grants or transfers, securities
sales, mineral rights and resource rights, as well as any sales that are
made.
For non-profits, revenue is often referred to as "gross receipts." Its
components include donations from individuals, foundations and
companies; grants from government entities; investments; fundraising
activities; and membership fees.
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EXPENSES
An expense consists of the economic costs a business incurs through
its operations to earn revenue. Businesses are allowed to write off
tax-deductible expenses on their income tax returns to lower
their taxable income and thus their tax liability. Common business
expenses include payments to suppliers, employee wages,
factory leases and equipment depreciation, but the Internal Revenue
Service has strict rules on which expenses business are allowed to
claim as a deduction.
 Deductible Business Expenses
According to the IRS, to be deductible, a business expense must be
both ordinary and necessary. Ordinary means the expense is common
or accepted in that industry, while necessary means the expense is
helpful in the pursuit of earning income. Business owners are not
allowed to claim their personal, nonbusiness expenses as business
deductions.
 Recording Expenses
Accountants record expenses through one of two accounting
methods: cash basis or accrual basis. Under cash basis accounting,
expenses are recorded when they are paid. For example, if a
business owner schedules a carpet cleaner to clean the carpets in his
office and the cleaner invoices the company for the service, a
company using cash basis records the expense when it pays the
invoice. Under the accrual method, however, expenses are recorded
when they are incurred, and to continue with the above example, the
business accountant records the carpet cleaning expense when the
company receives the service.
 Capital Expenses
The IRS treats capital expenses differently than most other business
expenses. While most costs of doing business can be expensed or
written off against business income the year they are incurred, capital
expenses must be capitalized or written off incrementally.
Capital expenses are typically large expenditures considered
investments into a company. They include business startup costs;
business assets such as real estate, vehicles, equipment and patents;
and improvements such as putting a new HVAC system into a
building. Rather than writing off these expenses in the year they are
incurred, business owners must write them off slowly over time. The
IRS has a schedule that dictates the portion of a capital asset a
business may write off each year until the entire expense is claimed.
The number of years over which a business writes off a capital
expense varies based on the type of asset.
MERCHANDISING BUSINESS
Merchandising businesses purchase inventory with the
intent of reselling it to a customer at a higher price. The accounting
terminology for a merchandising company is often distinct from a
service company, which provides a service to a customer in return for
payment. Merchandising businesses are subject to accounting
processes that are rarely, if ever, used in a service-oriented firm.
Cost of Goods Sold
A company that purchases goods to resell must account for the
acquisition of those items. Cost of goods sold is the accounting
terminology that describes the costs related to these purchases. The
cost of goods sold for a merchandising company would include
elements such as employee payroll, freight charges and merchandise
inventory purchases. The costs of goods sold is subtracted from the
company's net sales to determine the gross profit, from which the
operating expenses are subtracted to determine the net profit, also
called the bottom-line profit.
 Merchandise Inventory
Merchandise inventory refers to the items that are sold in a
merchandising business. The merchandise inventory for a golf shop
would include golf clubs, golf balls, apparel and golf-related
accessories. Merchandising businesses purchase these items from
their suppliers. These purchases, if made on a trade account, would
appear on the accounts payable sub-ledger until they are paid.
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  Purchase Returns and Allowances
Merchandising business may, from time to time, receive merchandise
inventory that is defective and is placed for sale on the sales floor. If a
customer purchases a defective item from a merchandising business
and returns it for a refund of the purchase price, the store receives the
item back, but it is not placed back into inventory. The store must
return the item to its supplier in return for a debit memorandum, or
debit memo, which reduces the amount due to that company on a
future invoice.
 Free on Board
Free on Board (FOB) determines which party of a business
transaction is responsible for shipping charges and also refers to the
location where ownership of merchandise inventory is transferred
from the seller of an item to the purchaser. There are four basic FOB
types: FOB Destination, FOB Origin, FOB Shipping Point and FOB
Shipping Point, Freight Prepaid. FOB Destination requires that the
seller of the item pay for the shipping costs of the item. In F.O.B.
Origin and FOB Shipping Point, the purchaser of the item pay for the
shipping costs of the item. FOB Shipping Point, Freight Prepaid
requires that the seller of the item pay for the shipping cost of the
item, then bill the purchaser of the item for the amount of the item plus
the shipping costs. FOB also refers to the point in time when
ownership of the item changes from seller to purchaser. In FOB
Destination, ownership is transferred to the purchaser when the item
is delivered to the purchaser's facility. FOB Origin and FOB Shipping
Point require ownership to be transferred to the purchaser when the
carrier picks the item up from the seller's facility.
INVENTORIES
Inventories consist of raw material, work-in-process and finished
goods which are held by a business in ordinary course of business,
either for sale or for the purpose of using them in the process of
producing goods and services.
Types of Inventory
1. Raw Material is a type of inventory which acts as the basic
constituent of a product. For example cotton is raw material for
cloth production and plastic is raw material for production of
toys. Raw material is usually held by manufacturing
companies because they have to manufacture goods from raw
material. Raw material to be used as input in manufacturing
process
2. Work-In-Process is a type of inventory that is in the process of
production. This means that work-in-process inventory is in the
middle of production stage and it is partly complete. Work-in-
process account is used by manufacturing companies. Goods
which are still in the process of converting to finished goods.
It’s not yet a finished good. (If your solution supports WIP)
3. Finished Goods is a type of inventory which comes into
existence after the production process in complete. Finished
goods is ready for sale inventory. In financial accounting we
are usually concerned with merchandise inventory. The other
types of inventories are studied in cost accounting. Completed
unit output from manufacturing process.
4. Cost of Inventory When inventory is purchased, the cost of
inventory includes the purchase price, delivery costs, excise
and custom duties etc. less any discount that is obtained.
When inventory is manufactured, its cost includes the
production cost plus any cost which is incured on making the
inventory saleable for example packing cost.
However if abnormal cost is incurred on delivery or handling etc. then
only normal portion will be added to the cost of inventory. The rest
should be expensed.
INCOME STATEMENT VS STATEMENT OF COMPREHENSIVE
INCOME
Income Statement and Statement of Comprehensive are
differentiated because IAS 1 gives two options to present the items of
incomes and expenses recognized during the period.
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IAS 1 para 81 allows that all the items of income and expenses
recognized in the period:

EITHER in a single statement i.e. Statement of Comprehensive

Income;

OR in two separate statements as follows:

Income Statement: With components of profit and loss recognized.

This statement includes regular line items which in the language of
IASs are known as profit and loss items.

Statement of other Comprehensive Income: This statement starts with

the profit or loss as calculated under Income statement and contains
components of other comprehensive income. Simply this
statement contains such line items which are not recognized in profit
or loss and if disclosed under Income Statement then it might mislead
users of financial statements as they may consider them as regular
line items.

The components of other comprehensive income include:

 changes in revaluation surplus (see IAS 16 Property, Plant and

Equipment and IAS 38 Intangible Assets);

 actuarial gains and losses on defined benefit plans

 gains and losses arising from translating the financial

statements of a foreign operation

 gains and losses from investments in equity instruments

measured at fair value through other comprehensive income

 the effective portion of gains and losses on hedging

instruments in a cash flow hedge (see IAS 39).

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