Chapter 3: ‎ Income Determination

Contents:

3.1

The Matching Principle: When to Record Expenses

3.1 The Matching Principle: When to Record Expenses

A significant relationship exists between revenue and expenses are incurred for the purpose of producing revenue. In measuring net income for a period, revenue should be offset by all the expenses incurred in producing that revenue. This concept of offsetting expenses against revenue on a basis of cause and effect is called the matching principle.

 Timing is an important factor in matching (offsetting) revenue with the related expenses. For example, in preparing monthly income statements, it is important to offset the month's expenses against this month's revenue. We should not offset this month's expenses against last month's revenue because there is no cause and effect relationship between the two.

3.2

Cash Effects

3.2 Cash Effects

Assume that the salaries earned by sales personnel waiting on customers during July are not paid until early August. In which month should these salaries be regarded as an expense – July or august?

 The answer is July, because this is the month in which the sales personnel's services helped to produce revenue. Just as revenue and cash receipts are not one and the same, expenses and cash payments are not identical, In fact, the cash payment of an expense may occur before, after, or in the same period that revenue is produced. In deciding when to record an expense, the critical question is: In what period does the cash expenditure help to produce revenue? "Not when does the cash payment occur? "

3.3

Expenditures Benefiting More Than One Accounting Period

3.3 Expenditures Benefiting More Than One Accounting Period

Much expenditure made by a business benefit two or more accounting periods. Fire insurance policies, for example, usually cover a period of 12 months. If a company prepares monthly income statements, a portion of the cost of such a policy should be allocated to insurance expense each month that the policy is in force. In this case, apportionment of the cost of the policy by months is an easy matter. If the 12 – month policy costs $2,400, for example, the insurance expense for each month amounts to $ 200 ($ 2.400 cost ÷ 12 months).

 Not all transactions can be divided so precisely by accounting periods. The purchase of a building, furniture and fixtures, machinery, a computer, or an automobile provides benefits to the business over all the years in which such asset is used. No one can determine in advance exactly how many years of service will be received form such long lived asset. Since the allocation of these costs are estimates rather than precise measurements. It follows that income statements should be regarded as useful approximations of net income rather than as absolutely correct measurements. 

For some expenditure, such as those for advertising or employee training programs, it is not possible to estimate objectively the number of accounting periods over which revenue is likely to be produced. In such cases, generally accepted accounting principles require that the expenditure charged immediately to be expense. This treatment is based upon the accounting principle of objectivity and the concept of conservatism. Accountants require objective evidence that expenditure will produce revenue in future periods before they will view the expenditure as creating an asset. When this objective evidence does not exist. They follow the conservative practice of recording the expenditure as an expense. Conservatism, in this context, means applying the accounting treatment those results in the lowest (most conservative) estimate of net income for the current period.

3.4

Case in Point

3.4 Case in Point

Internationally, there is a significant disagreement about whether some business expenditures should be immediately expensed or can be recorded as an asset. In particular, research and development costs, which must be expensed as incurred under U.S. accounting standards, can be either expensed immediately or recorded as an asset in Sweden and Italy and in Egypt expenses of a long or medium-term investment are recorded as an asset.

3.5

The Accrual Basis of Accounting

3.5 The Accrual Basis of Accounting

Airlines sell many tickets weeks or even months in advance of scheduled flights. Yet many expenses relating to a flight – such as salaries of the flight crew and the cost of fuel used may not be paid until after the flight has occurred. Recognizing these events when cash is received or paid would fall of "Match" revenues and expenses in the period when flights actually occur.

3.6 

Cash in Point

3.6 Cash in Point

Airlines sell many tickets weeks or even months in advance of scheduled flights. Yet many expenses relating to a flight – such as salaries of the flight crew and the cost of fuel used may not be paid until after the flight has occurred. Recognizing these events when cash is received or paid would fall of "Match" revenues and expenses in the period when flights actually occur.

3.7

Debit and Credit Rules for Revenue and Expenses

3.7 Debit and Credit Rules for Revenue and Expenses

We have stressed that revenue increases owner's equity and that expenses decrease owner's equity. The debit and credit rules for recording revenue and expenses in the ledger accounts are a natural extension of the rules for recording changes in owners' equity. The rules previously stated for recording increases and decreases in owners; equity is as follows:

-          Increases in owners' equity are recorded by credits.

-          Decreases in owner's equity are recorded by debits.

 The rule is now extended to cover revenue and expense accounts:

Revenue increases owners' equity: therefore. Revenue is recorded by a credit.

 Expenses decrease owners' equity: therefore. Expenses are recorded by debits.

3.8

Dividends

3.8 Dividends

A dividend is a distribution of assets (usually cash) by a corporation to its stockholders. In some respects, dividends are similar to expenses – they reduce both the assets and the owner's equity in the business. However, dividends are not expenses, and they are not deducted from revenue in the income statement. The reason why dividends are not viewed as expense is that these payments do not serve to generate revenue. Rather, they are a distribution of profits to the owners of the business.

 Since the declaration of dividends reduces stockholders equity the dividend could be recorded by debiting the retained Earnings account.  However, a clearer record is created if a separate dividend account is debited for all amounts distributed as dividends to stockholders.

The debit–credit rules for revenue expense and dividends are summarized in Table 3.1: 

Table 3.1: The debit–credit rules for revenue expense and dividends