Transcript

Slide 2: Let us apply this principle to the following problem

Excalibur Shipping Company sells ships. Each ship sells for over $25 million. Brad never starts building a ship until it receives a specific order from a customer. Brad usually takes about four years to build a ship. After construction is completed and during the first three years the customer uses the ship, Brad agrees to repair anything on the ship free of charge. The customers pay for the ships over a period of ten years after the date of delivery

Slide 3: So…when should Excalibur Shipping Company. If you answered 3 or 4 you are correct. The revenue from most construction projects is proportionally recognized during the a construction period. More conservatively you would recognize the revenue after the customer took possession. This is a policy decision made by the organization. This can be an area where individuals are tempted to manage earnings so that their financial statements look healthier than they are actually.

Slide 4: The matching principle states that all costs and expenses incurred in generating revenue must be recognized or matched in the same reporting period as the related revenues. Essentially the costs of generating the current cycle’s revenue must be matched up with during the same cycle. This too has been an area where individuals are tempted to push expenses into the next period in order to show a healthier statement. Recognizing revenue and matching the appropriate expenses is important to providing an accurate performance or profit picture for the period.

Slide 5: Let us use a problem to further illustrate.

American Flag Makers Inc manufactured 15,000 flags during the 2003 calendar year. They sold 12,000 flags for $15.00 each and each flag they made cost them $8.00. They also incurred over the year $25,000 in selling expenses and $32,000 in General and Administrative Expenses. Prepare a multi-step income statement and explain how you used the matching principle concept in its preparation

Slide 6: See slide 6 for the income statement. Notice that we only took into account when determine revenue and cost of goods sold the 12,000 flags we sold and not the entire 15,000 flags we manufactured. This is an example of the matching principle at work.

Slide 7: At this time I would like to introduce to you the concept of accrual accounting. Before we get into that we need to go over a couple of concepts. The first concept is that of “time period”. This is the idea that a business’ life is divided into distinct and relatively short time periods so that accounting information can be timely. Related to the time period concept is the idea of fiscal year. This is the entity’s reporting year. In other words this is the yearly time frame that accounting information is collected and reported. Some organizations report on the last day of the year … December 31, XXXX. We call them calendar year companies. Other companies report during some other time besides December 31. Usually the reporting cycle corresponds to their related business cycle. For instance the University of Idaho closes its books on June 30. The main reason for doing this is that summer is the slow time of the year for the university. It takes significant effort to close all the accounts and prepare the related reports. So you want to do it during the slowest part of your business cycle.

Slide 8: Now onto accrual accounting. Accrual accounting basically is the embodiment of the revenue recognition principle and the matching principle. Essentially when using accrual accounting you recognize the revenue when it is earned and not necessarily when you receive the cash for the sale or service. All related expenses to the revenue are matched during the reporting period even if they have not been paid. If we were using cash basis accounting we would only recognize when cash was received or paid out. This can distort the true performance of an organization. Particularly at the end of a reporting cycle as we will see in the next module.