![]() The COGS must be matched with the associated revenues. The products were delivered to the customer in year 2 so revenue can be recognized during this period. However, the product was not sold until year 2. If we start with year 1, we can see that the materials were purchased with cash. The income statement has two line items which are going to be affected, revenue and cost of goods sold (COGS). In which period will the transactions be recognized in each of the financial statements? Income Statement Cash from the customer is received in Year 3. They are sold on credit and delivered to the customer in Year 2. Materials are bought with cash in Year 1. Expenses are matched with revenues for the period using the accruals concept.Revenue recognition is an accounting principle which looks at when revenue can be recognized in an accounting period (typically when the revenues is earned and when the product or service has been delivered).The income statement is built on the accruals concept which means sales and expenses are recognized in the period in which they are generated.$100,000 worth of monthly salaries should be matched with $500,000 of revenue generated. Since $100,000 worth of inventories are to be sold in next period, they should not be subtracted from revenue for the current period.Įxample 3: A hospital pays $20,000 per month to 5 of its doctors. The main point is to subtract only that much expense in a particular period which is related to the revenues earned in that period. The cost of sales should be reflected in the income statement at $900,000. Total purchases of inventories were $1,000,000 of which $100,000 remained on hand at the end of 2010. Recognizing bad debts expense requires considerable estimation.Įxample 2: Company B generates $2,000,000 in revenue in 2010. ![]() The possibility of bad debts exists when the sale is made, so expense should be recognized right at that moment when the sale is made. Now, there is a risk that the customers may not pay the amount due against those sales, which results in the company writing off the account receivable as bad debts expense. ![]() In accordance with revenue recognition principle, revenue is recognized when the delivery is made. where the customer receives delivery of goods or services but promises to make the payment, say within 30 days. ExamplesĮxample 1: When a company makes sales, majority of it are against credit, i.e. In line with the materiality concept, a company is not required to trace every dollar of expense to every dollar of revenue because the cost of doing so would exceed the potential benefit. Prudence concept, which is a related accounting principle, requires companies not to overstate revenues, understate expenses, overstate assets and/or understate liabilities. In order to apply the matching principle, management of a company is required to apply judgment to estimate the timing and amount of revenues and expenses. It requires recognition of revenues and expenses regardless of the actual receipt of cash from revenues and actual payment of cash for expenses. Matching principle is what differentiates the accrual basis of accounting from cash basis of accounting. If expenses are not properly recorded in the correct period, the net income for a particular period may be either understated or overstated and so are the related balance sheet balances. the net amount earned in a period, is calculated by subtracting expenses from revenues. ![]() It is important to match expenses with revenues because net income, i.e. Matching concept is at the heart of accrual basis of accounting. It requires that a company must record expenses in the period in which the related revenues are earned. Matching principle is one of the most fundamental principles in accounting. ![]()
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