Lessons 5 & 6

Introduction
◼ Suppose you decide to earn some pocket money by renting a
stall to sell Coca-cola collectibles in the weekend flea market.
◼ The transactions for your first day of business is as follows:-
1. Pay rental of $200 for the use of a stall for 4 consecutive
Sundays.
2. Paid for a mat and small chair for use in the business costing
$40.
3. Bought 50 pieces of collectibles at $3 each for sale at $6 each.
50% of the amount (ie $75) was paid for in cash and the balance
in 2 weeks’ time.
4. Sold 30 pieces of collectible at $6 each for cash. (Total amt =
$180)
◼ Calculate the profit (or loss) you have earned in your first day
of business.
Calculation of profits for 1st day – Case 1

Sales revenue $6 x 30 = $180

Less expenses:
- payment for collectibles $75
- stall rental paid $200
- mat & chair
$40
$315
Net loss ($135)
Calculation of profits for 1st day – Case 2

Sales revenue $6 x 30 = $180

Less expenses:
- cost of goods sold $3 x 30 = $90
- stall rental $200/4 days = $50
- mat & chair $40/4 days = $10
$150
Net profit $30
Calculation of profits for 1st day

◼ Which case do you think is a better

reflection of the business activities for the
1st day?
◼ Which case gives a better measurement of
the business performance for the 1st day?
ACCRUAL BASIS OF ACCOUNTING
◼ Revenue and expense recognition
– Should revenue be recognised when earned or
when it is collected in cash?
– Should expenses be recognised when incurred or
when finally paid?

◼ Financial activity of the business is not adequately

measured if business records revenue only when
cash is received and expenses when cash is paid

◼ Revenues and expenses may not be properly

matched
 Consider Richie Services’ sequence of events

--------------> time passes

Accounting year-end
Accounting year-end

----|-------------------------|---------------------|------------------|-----------------------|-------
20/12/2013 22/12/2013 31/12/2013 3/1/2014 5/2/2014

Sales or Delivery of Invoicing Payment by

service goods/ customers
orders services
received rendered

Assume the transaction above is for the sale of a huge amount.

Should this sale be recorded as belonging to 2013 or 2014? Why?
 Consider Richie Services’ sequence of events

--------------> time passes

Accounting year-end
Accounting year-end

----|-------------------------|---------------------|------------------|-----------------------|-------
20/12/2013 22/12/2013 31/12/2013 3/1/2014 5/2/2014

Purchase Lifts Invoice Payment to

order for lift maintenance received vendor
service completed

Assume the transaction above is for the business lifts to be serviced.

Which period does the lift maintenance expense belong to? Why?
REVENUE RECOGNITION
◼ Transactions should be recorded in the period that
they belong
◼ Revenue is recognised in the period in which they are
earned
– when goods are sold or when services are rendered.
◼ Expenses are recorded when incurred
– when benefits are received from the use of assets
– when unexpired costs becomes expired

◼ Important :
– Note that whether revenue has been earned or expense
incurred does NOT depend on the receipt and payment of
cash.
 Consider Richie Services’ sequence of events
--------------> time passes

Accounting year-end

----|-------------------------|---------------------|------------------|-----------------------|-------
20/12/2013 22/12/2013 31/12/2013 3/1/2014 5/2/2014

Sales or Delivery of Invoicing Payment by

service goods/ customers
orders services
received rendered
Revenue is earned on 22/12/2013 (delivery date) and NOT 5/2/2014 (receipt date).
The sale belongs to the accounting period ending 31/12/2013.

Accrual basis
 Consider Richie Services’ sequence of events

--------------> time passes

Accounting year-end

----|-------------------------|---------------------|------------------|-----------------------|-------
20/12/2013 22/12/2013 31/12/2013 3/1/2014 5/2/2014

Purchase Lifts Invoice Payment to

order for lift maintenance received vendor
service completed

Expense is incurred on 22/12/2013 and NOT 5/2/2014 .

The expense belongs to the accounting period ending 31/12/2013.

Accrual basis
THE MATCHING PRINCIPLE
◼ Operating life cycle of business is broken into
accounting periods

◼ Therefore necessary to identify revenue and expense

to the period that they belong.

◼ Revenue earned in a period must be properly

matched with expenses related to earning that
revenue.

◼ Eg: Revenue from the sale of inventory must be

matched with the cost of goods sold in the same
period. (matching principle.)
THE MATCHING PRINCIPLE

◼ Some expenses cannot be matched directly to the

revenue generated, these are matched to the period
which have benefited from that expenditure.

◼ Eg: Human Resource Manager’s salary is matched

to the period when he worked.
THE MATCHING PRINCIPLE
Exercise - Calculating your own Pay Cheque
◼ Assume payday is on every 15th of the month.
◼ If you resign and the last day of work is on 10 June
2000, calculate the salary you have earned for the
month of June 2000.
◼ Would you protest if the employer’s response is
“You have been paid on the 15th of May, and the next
payday is not till the 15th June. We are therefore not
paying anything when you leave”.
◼ Since you have worked for the company for 10 days in
June, you should be paid for the 10 days’ work. Ie. The
Company must record the salaries expense for the 10
days of labour cost.
PERIOD END ADJUSTMENTS
◼ Certain adjustments to the accounts are necessary to
comply with the accrual basis of accounting
◼ This is to ensure that the correct amount of revenue
earned and expenses incurred in the accounting
period are properly recorded
◼ Refer to illustration on Richie Services
- The sale may not be recorded in 2013 as the
invoice was prepared only in 2014
- The expense (lift maintenance) may not be
recorded in 2013 as the supplier’s invoice is only
received in 2014
- Documents for business transactions may be
delayed due to work procedures
PERIOD END ADJUSTMENTS
Adjustsments to accounts include
◼ a) Prepaid expenses
– A business paid for insurance cover, say $1,200 for 1 year
from 1/12/2000.
– As of 31/12/2000, only one-twelfth of the premium paid will
be considered expensed. The remaining 11 months will be
shown as an asset (bundle of future benefits) as Prepaid
Insurance.

◼ b) Accrued expense / Expense Payable

– Conversely, if the business had used electricity, water for the
month of December 2000 (expense). But it has not paid for
utilities, it will have liability in the form of Utilities Payable.
Illustration-Prepaid Expenses
Accounting
Accountingyear-end
year-end
1 Jan 2000 31 Dec 2000 30 Nov 2001

Revenue earned
Expenses incurred

Net profit for 2000 1 mth insurance 11 mth

exp shd be insurance shd
recorded in 2000 be recorded as
P&L exp in 2001

1 yr insurance paid Therefore, this

amt is
on 1 Dec
considered as
prepaid
insurance as at
31 Dec 2000
(current asset in
Stmnt of FP)
Illustration-Accrued Expenses
Accounting
Accountingyear-end
year-end
1 Jan 2000 31 Dec 2000

Revenue earned
Expenses incurred

Net profit for 2000 Used electricity &

water for Dec 2000
but have not
received the bill.

The amount of utilities

exp shd be estimated
and recorded in 2000
P & L (Stmnt of CI)
PERIOD END ADJUSTMENTS
Adjustsments to accounts include
◼ c) Unearned Revenue
– Revenue is earned only when service is performed or when
goods are delivered.
– Eg Landlord received rental of $1,500 for the next 3 months
(Dec 2000 to Feb 2001),
– tenant has occupied the premise for only one month (Dec
2000)
– The landlord has earned only one third of the money
received ($500).
– The remaining 2 months rental will be shown as a liability
($1000) Unearned Revenue. He owes the tenant a service.
Period End Adjustsments
◼ From the viewpoint of the tenant, how will the
$1,500 paid be treated?
-$500 as rental expense; $1,000 as Prepaid
Rental.

◼ d) Accrued revenue / Revenue Receivable

– In another apartment, another tenant had been
occupied the premise for a month but had not paid
the rental.
– The landlord will have earned the revenue and
has an asset (Account Receivable)
Illustration-Unearned Revenue
Accounting
Accountingyear-end
year-end
1 Jan 2000 31 Dec 2000 28 Feb 2001

Revenue earned
Expenses incurred

Net profit for 2000 1 mth rental 2 mths rentals

revenue hd be recorded
recorded in 2000 as revenue in
Stmnt of CI 2001

3 mths rental 1 Dec Therefore, this

amt is
considered as
unearned
revenue as at 31
Dec 2000
(current liability
in Stmnt of FP)
Illustration-Accrued Revenue
Accounting
Accountingyear-end
year-end
1 Jan 2000 31 Dec 2000

Revenue earned
Expenses incurred

Net profit for 2000 Apartment was

occupied by tenant in
Dec 2000.
The rental revenue
shd be recorded in
2000
Stmnt of CI