Question

Explain the revenue recognition principle and the matching principle. Differentiate between the cash basis and the accrual basis of accounting. Explain why adjusting entries are needed and identify the major types of adjusting entries.

Answer 1

Solution:

According to the revenue recognition principle companies record revenue in their books of accounts in the accounting period in which it is realized and earned generally after goods are transferred or services are rendered irrespective of when cash is received. In other words accountants should not wait for payment for goods or services to record revenue in their books.

Matching principle states that an expense should be charged to the income statement in the period in which its related revenues are earned. It is a systematic allocation of the costs to the period in which these are incurred. It helps in creating consistency in the income statements as recording an expense in the correct accounting period portrays the true picture of the financial performance of the entity.

In cash basis of accounting we record revenues and expenses when actual cash has been realized or paid. So, revenue recognition is delayed to the point of time when cash has actually been received from customers. Similarly no matching principle is followed here as expense are recorded when cash has been paid to suppliers irrespective of the period in which the expense has incurred. This basis for accounting are generally followed by small businesses as it is simple to understand.

In accrual basis of accounting , revenues are recognized when they are earned and expenses are recorded when they are consumed by the business. Unlike the cash basis of accounting revenue is recorded when the goods or services are delivered with the expectation that cash will be received in future. Due to presence of trade receivable and payable it gives a more accurate picture of profitability than cash basis of accounting.It is generally followed by large companies and is more popular because of its completeness to record all revenues and expenses as and when generated.

Adjusting entries are needed because a single transaction may affect revenues and expenses of more than one period. Generally on the last day of the accounting year adjusting entries are recorded to comply with the accrual concept.

The major types of adjusting entries are:

1) Accrued revenues - Entries for recording revenues earned but cash not received will be made by debiting receivables and crediting revenue.When cash is received we adjust by debiting cash and crediting receivables.

2) Prepaid expenses- Expenses paid today but incurred in future would be recorded today by debiting prepaid expenses and crediting cash and would be adjusted in future by debiting expense and crediting prepaid expense.

3) Deferred revenue- Cash received for goods or services not delivered today will be recorded by debiting cash and crediting deferred revenue account. As goods are delivered in future an adjusting journal entry would be prepared by debiting the deferred revenue account and crediting the revenue account.

4) Accrued Expense - At the end of the accounting period when any expense has not been paid, but has to be recorded this year because of accrual concept will be recorded by debiting expense and crediting payable. When the expense is paid, we debit payable and credit cash.