Accounting Principles

Accounting follows a certain framework of core principles which makes the information generated through an accounting system valuable. Without these core principles accounting would be irrelevant and unreliable.
These principals include:

1. Accrual Concept
2. Going Concern Concept
3. Business Entity Concept
4. Monetary Unit Assumption
5. Time Period Principle
6. Revenue Recognition Principle
7. Full Disclosure Principle
8. Historical Cost Concept
9. Matching Principle
10. Relevance and Reliability
11. Materiality Concept
12. Substance Over Form
13. Prudence Concept
14. Understandability Concept
15. Comparability Principle
16. Consistency Concept

These principles are the building blocks that form the basis of more complex and specialized principles called GAAP or generally accepted accounting principles such as the International Financial Reporting Standards, US GAAP, etc. They deal with matters like accounting for revenue, accounting for income taxes, accounting for business combinations, etc.

Accrual Concept

Business transactions are recorded when they occur and not when the related payments are received or made. This concept is called accrual basis of accounting and it is fundamental to the usefulness of financial accounting information.

Examples:

1. An airline sells its tickets days or even weeks before the flight is made, but it does not record the payments as revenue because the flight, the event on which the revenue is based has not occurred yet.
2. An accounting firm obtained its office on rent and paid $120,000 on January 1. It does not record the payment as an expense because the building is not yet used. While preparing its quarterly report on March 31, the firm expensed out three months' rent i.e. 30,00 [$120,000/12*3] because 3 months equivalent of time has expired.
3. A business records its utility bills as soon as it receives them and not when they are paid, because the service has already been used. The company ignored the date when the payment will be made.

Accounting standards strictly require accounting on accrual basis. However, there is an alternative called cash basis of accounting. Under the cash basis events are recorded based on their underlying cash inflows or outflows. Cash basis is normally used while preparing financial statements for tax purpose,etc.

Going Concern Concept 

Financial statements are prepared assuming that the company is a going concern which means that the company intends to continue its business and is able to do so.

The status of going concern is important because if the company is a going concern it has to follow the generally accepted accounting standards.
The auditors of the company determine whether the company is a going concern or not at the date of the financial statements.

Examples

1. An oil and gas firm operating in Nigeria is stopped by a Nigerian court from carrying out operations in Nigeria. The firm is not a going concern in Nigeria, because it has to shut down.
2. A nationalized refinery is in cash flows problems but the government of the country provided a guarantee to the refinery to help it out with all payments, the refinery is a going concern despite poor financial position.
3. A bank is in serious financial troubles and the government is not willing to bail it out. The Board of Directors has passed a resolution to liquidate the business. The bank is not a going concern.
4. A merchandising company has a current ratio below 0.5. A creditor $1,000,000 demanded payment which the company could not make. The creditor requested the court to liquidate the business and recover his debts and the court grants the order. The company is no longer a going concern.

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Business Entity Concept

In accounting we treat a business or an organization and its owners as two separately identifiable parties. This concept is called business entity concept. It means that personal transactions of owners are treated separately from those of the business.
Businesses are organized either as a proprietorship, a partnership or a company. They differ on the level of control the ultimate owners exercise on the business, but in all forms the personal transactions of the owners are not mixed up with the transactions and accounts of the business.

Examples

1. A CPA has 3 rooms in a house he has rented for $3,000 per month. He has setup a single-member accounting practice and uses one room for the purpose. Under the business entity concept, only 1/3rd of the rent or $1,000 should be charged to business, because the other 2 rooms or $2,000 worth of rent is expended for personal purposes.
2. The CPA received $900 bill for utilities. He paid the whole amount using his business account. $600 is to be considered a withdrawal because only $300 (1/3rd) related to business and the other $600 was for domestic purpose.
3. Assuming each public accounting business is required to pay $100 to a local association of CPAs each month. If the CPA pays that amount from a personal bank account the amount shall be considered additional capital.

Monetary Unit Assumption

In accounting we can communicate only those business transactions and other events which can be expressed in monetary units. This is called monetary unit assumption.
There are certain other frameworks for reporting business performance such as triple bottom line which focuses on "people, planet profit" the three pillars; corporate social responsibility reporting, etc. Accounting focuses on the financial aspects of the business and that too for matters which can be expressed in terms of currencies.
One aspect of the monetary unit assumption is that currencies lose their purchasing power over time due to inflation, but in accounting we assume that the currency units are stable in value. This is alternatively called stable dollar assumption.
However, there are exceptional circumstances called hyperinflation when the accounting standards require adjustment of prior period figures.

Examples

1. The company's property, plant and equipment on 2009 balance sheet amounted to $2 billion. During 2010 inflation was 10%. The monetary unit and stable dollar assumption prohibits any adjustment to current or prior period figures to account for the inflation.
2. The BP oil spill in Gulf of Mexico was a natural disaster but accounting only reports the financial impact in the form of claims paid, damages paid, cleanup costs, etc. This is due to the limitation imposed by the monetary unit assumption.

 

Time Period Principle

Although businesses intend to continue in long-term, it is always helpful to account for their performance and position based on certain time periods because it provides timely feedback and helps in making timely decisions.
Under time period assumption, we prepare financial statements quarterly, half-yearly or annually. The income statement provides us an insight into the performance of the company for a period of time. The balance sheet (also known as the statement of financial position) provides us a snapshot of the business' financial position (assets, liabilities and equity) at the end of the time period. The statement of cash flows and the statement of changes in equity provide detail of how the company's financial position changed during the time period.
One implication of the time period assumption is that we have to make estimates and judgments at the end of the time period to correctly decide which events need to be reported in the current time period and which ones in the next.
Revenue recognition and matching principles are relevant to time period assumption. Revenue recognition principle provides guidance on when to record revenue while matching concept tells us how to reach an accurate net income figure by creating 1-1 correspondence between revenues and expenses.

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Revenue Recognition Principle

Revenue recognition principle tells that revenue is to be recognized only when the rewards and benefits associated with the items sold or service provided is transferred, where the amount can be estimated reliability and when the amount is recoverable.
Accrual basis of accounting is used in recognizing revenue which tells that revenue is to be recognized ignoring when the cash inflows occur.

Examples

1. A telecommunication company sells talk time through scratch cards. No revenue is recognized when the scratch card is sold, but it is recognized when the subscriber makes a call and consumes the talk time.
2. A monthly magazine receives 1,000 subscriptions of $240 to be paid at the beginning of the year. Each month it recognizes revenue worth $20,000 [($240 ÷ 12) × 1,000].
3. A media company recognizes revenue when the ads are aired even if the payment is not received or where payment is received in advance.

In case where payment is received before the event triggering recognition of revenue happens, the debit goes to cash and credit to unearned revenue. In case the event triggering revenue recognition occurs before payment is received, the debit goes to accounts receivable and credit to revenue.
Revenue is the item which is the easiest to misstate, hence more stringent rules and guidance is required in this area. IAS 18 Revenue deals with recognition of revenue.

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Full Disclosure Principle

Full disclosure principle is relevant to materiality concept. It requires that all material information has to be disclosed in the financial statements either on the face of the financial statements or in the notes to the financial statements.

Examples

1. Accounting policies need to be disclosed because they help understand the basis of accounting.
2. Details of contingent liabilities, contingent assets, legal proceedings, etc. are also relevant to the decision making of users and hence need to be disclosed.
3. Significant events occurring after the date of the financial statements but before the issue of financial statements (i.e. events after the balance sheet date) need to be disclosed.
4. Details of property, plant and equipment cannot be presented on the face of the balance sheet, but a detailed schedule outlining movement in cost and accumulated depreciation should be presented in the notes.
5. Tax rate is expected to change in near future. This information needs to be disclosed.
6. The draft for a new legislation is presented in the legislative of the country in which the company operates. If passed, the law would subject the company to significant cleanup costs. The company has to disclose the information in the notes.
7. The company sold one of its subsidiaries to the spouse of one of its directors. The information is material and needs disclosure.

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Historical Cost Concept

Accounting is concerned with past events and it requires consistency and comparability that is why it requires the accounting transactions to be recorded at their historical costs. This is called historical cost concept.
Historical cost is the value of a resource given up or a liability incurred to acquire an asset/service at the time when the resource was given up or the liability incurred.
In subsequent periods when there is appreciation is value, the value is not recognized as an increase in assets value except where allowed or required by accounting standards.

Examples

1. 100 units of an item were purchased one month back for $10 per unit. The price today is $11 per unit. The inventory shall appear on balance sheet at $1,000 and not at $1,100.
2. The company built its ERP in 2008 at a cost of $40 million. In 2010 it is estimated that the present value of the future benefits attributable to the ERP is $1 billion. The ERP shall stand on balance sheet at its historical costs less accumulated depreciation.

The concept of historical cost is important because market values change so often that allowing reporting of assets and liabilities at current values would distort the whole fabric of accounting, impair comparability and makes accounting information unreliable.

 

Matching Principle

In order to reach accurate net income figure, the expenses incurred to earn the revenues recognized during the accounting period should be recognized in that time period and not in the next or previous. This is called matching principle of accounting.

Examples

1. $2,000,000 worth of sales are made in 2010. Total purchases of inventory were $1,000,000 of which $100,000 remained on hand at the end of 2010. The cost of earnings is $2,000,000 revenue is $900,000 [$1,000,000 minus $100,000] and this should be recognized in 2010 thereby yielding a gross profit of $1,100,000.
2. A hospital pays $20,000 per month to 5 of its doctors. Monthly sales are $500,000. $100,000 worth of monthly salaries should be matched with $500,000 of revenue generated.

Matching principle is relevant to the time period assumption, the revenue recognition principle and it is at the heart of accrual basis of accounting.

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Relevance and Reliability

reliability are two of the four key qualitative characteristics of financial accounting information. The others being understandability and comparability.
Relevance requires that the financial accounting information should be such that the users need it and it is expected to affect their decisions.
Reliability requires that the information should be accurate and true and fair.
Relevance and reliability are both critical for the quality of the financial information, but both are related such that an emphasis on one will hurt the other and vice versa. Hence, we have to trade-off between them. Accounting information is relevant when it is provided in time, but at early stages information is uncertain and hence less reliable. But if we wait to gain while the information gains reliability, its relevance is lost.

Examples

1. After the balance sheet date but before the date of issue a company wants to dispose of one of its subsidiaries and is in final stages of reaching a deal but the outcome is still uncertain. If the company waits they are expected to find more reliable information but that would cost them relevance. The information would be outdated and no longer very relevant.
2. After the balance sheet date during the time when audit is carried out, it becomes clear which debts were realized and where were not hence it improves the reliability of allowance for bad debts estimate but the information loses its relevance due to too much time being taken. Timeliness is key to relevance.

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Materiality Concept

Financial statements are prepared to help the users with their decisions. Hence, all such information which has the ability to affect the decisions of the users of financial statements is material and this property of information is called materiality.
In deciding whether a piece of information is material or not requires considerable judgment. Information is material either due to the amount involved or due to the importance of the event.

Examples

1. The government of the country in which the company operates in working on a new legislation which would seriously impair the company's operations in future. Although there are no figures involved but the impact is so large that disclosure is imminent.
2. The remuneration paid to the executives and the directors is material.
3. The accounting policies are material because they help the users understand the figures.

Materiality might be based on a percentage of sales such as 0.5% of sales or on total assets. Materiality is helpful in determining which figures are to be reported on income statement and balance sheet and which one in the notes. It is also helpful in helping decide which items should appear as line items and which ones are aggregated with others.

Written by Abdully Ismail mossa

Substance Over Form

While accounting for business transactions and other events, we measure and report the economic impact of an event instead of its legal form. This is called substance over form principle. Substance over form is critical for reliable financial reporting. It is particularly relevant in case of revenue recognition, sale and purchase agreements, etc.

Examples

1. A lease might not transfer ownership to the leasee but the leasee has to record the leased items as an asset if it intends to use it for major portion of its useful life or where the present value of lease payment is fairly equal to the fair value of the asset, etc. Although legally the leasee is not the owner, so the leased item is not his asset, but from the perspective of the underlying economics the leasee is entitled to the benefits embedded in the use of the item and hence it has to be recorded as an asset.
2. A company is short of cash, so it sells its machinery to the bank and obtains it back on a lease. It is called sale and leaseback. Although the legal ownership has transferred but the underlying economics remain the same and hence under the substance over form principle the sale and subsequent leaseback are considered one transaction.
3. If two companies swap their inventories they will not be allowed to record sales because not sales has occurred even if they have entered into valid enforceable contracts.

Prudence Concept

Accounting transactions and other events are sometimes uncertain but in order to be relevant we have to report them in time. We have to make estimates requiring judgment to counter the uncertainty. While making judgment we need to be cautious and prudent. Prudence is a key accounting principle which makes sure that assets and income are not overstated and liabilities and expenses are not understated.

Examples

1. Bad debts are probable in many businesses, so they create a special contra-account to accounts receivable called allowance for bad debts which brings the accounts receivable balance to the amount which is expected to be realized and hence prevents overstatement of assets. An expense called bad debts expense is also booked to stop net income from being overstated.
2. Some liabilities are contingent upon future occurrence or non-occurrence of an event such a law suit, etc. We judge the probability of occurrence of that event and if it is more than 50% we record a liability and corresponding expense at the most likely amount. Hence, we stop liability and expense from being understated.
3. Periodic evaluations of assets are made to make sure their carrying value does not exceed the benefits expected to be derived from the asset, and if it does exceed, the impairment of fixed asset is recorded by reducing its carrying amount.

Written by Abdully Ismail mossa

Understandability Concept

Understandability is one of the four qualitative characteristics of financial accounting information. The other being relevance, reliability, timeliness, faithful representation, comparability and materiality. Understandability refers to the quality of financial information which makes it understandable by people with reasonable background knowledge of business and economic activities.
Understandability requires the information presented in financial reports to be concise, complete and clear in presentation. The information should be presented so as to facilitate the user of the information.
However, understandability never prescribes any complex information to be omitted altogether due to its underlying difficulty in understanding. It just requires us to disclose the information systematically instead of presenting it haphazardly.

Examples

Understandability would require the financial statements to be identified by presenting the name of the financial statement, the name of the entity and the period covered by the statement.
Understandability also requires the notes to be properly numbered and cross-referred to the original balance sheet and income statement items. For example the note number of disclosure on leases should be mentioned in front of the lease payable line item appearing on the face of a balance sheet.
Financial instruments and derivatives are specialized instruments which require rigorous understanding of finance to properly understand the underlying economics. In such complexity we cannot omit the disclosure because it is not easily understandable.

Written by Abdully Ismail mossa

Comparability Principle

Comparability is one of the key qualities which accounting information must possess. Accounting information is comparable when accounting standards and policies are applied consistently from one period to another and from one region to another. The characteristic of comparability of financial statements is important because it allows us to compare a set of financial statements with those of prior periods and those of other companies.

Examples

1. We can compare 20X2 financial statements of ExxonMobil with its 20X1 financial statements to know whether performance and position improved or deteriorated.
2. We can compare the ExxonMobil financial statements with that of BP if both are prepared in accordance with same set of accounting standards, such as IFRS or US GAAP, etc.
3. When preparing 20X3 financial statements we are required to present with each of the 20X3 figure the corresponding 20X2 figures. This is done to add the characteristic of comparability to the financial statements.

Accounting standards are intended to outline the best accounting treatment so that companies follow them and hence accounting information is understandable, relevant and reliable and comparable. Consistency means that the accounting policies should be changed only when there are valid grounds for such a change.

Written by Abdully Ismail mossa

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The eleven (11) Functions of marketing you must know

To achieve success in your marketing effort you need to have glimpse of the big pictures and the activities you need to perform in achieving your set marketing objectives, these activities is referred to as

the function of marketing. It refers to those specialize activities that you as a marketer must perform in order to achieve your set marketing objectives.

The ten (11) functions of marketing are;

· Researching
· Buying
· Product development and management
· Production
· Promotion
· Standardization and grading
· Pricing
· Distribution
· Risk bearing
· Financing
· After sales-service

(1) Research function: the research function of marketing is that function of marketing that enables you to generate adequate information regarding your particular market of target. You must carry out adequate research to identify the size, behavior, culture, believe, genders etc. of your target market segment, their needs and want, and then develop effective product that can meet and satisfy these market needs and want.

(2) Buying function: the function of buying is performed in order to acquire quality materials for production. When you design a good product concept, you should also ensure you're buying the essential materials for the product. This function is carried out by the purchase and supply department, but your specifications of materials goes a long way in assisting the purchasing department to acquire the necessary materials needed for production.

(3) Product development and management: product development is an essential function of marketing since it was the duties of the marketing department to identify what the market need or want and then design effective product based on the identified need and want of the market. Product development passes through some basic stages carried out by the marketers to develop a targeted market specified product. And you can also manage your product by evaluating it performance and changing them to fit the current market trend.


(4) Production function: production is the function performs by the production department. Though, this is interrelated to the department of marketing, because your product must possess the essential characteristics that can meet the target market needs and want as identified during your market research, such characteristics as in your product Test, Form, Packaging etc.

(5) Promotion function: promotion is one of the core functions of marketing since your finish product must not remain in the place of production, hence, you as a marketer must design effective communication strategies to informing the availability of your product to your target market.

You must be able to design effective strategies to communicate your product availability and features to your target market, such strategies as in; advertisement, personal selling, public relation etc.

(6) Standardization and grading: the function of standardization is to establish specified characteristics that your product must conform to, such standard as in having a specify test, ingredient etc. That makes your product brand so unique. 

Grading comes in when you sort and classify your product into deferent sizes or quantities for different market segment while maintaining your product standard.

(7) Pricing function: you perform the function of pricing on your product offerings by designing effective pricing systems base on your product stage and performance in the product life cycle. Price is the actual value consumers perceive on your product, so you as a marketer should ensure that your value of your product is not too high or too low to that of your costumers.

(8) Distribution function: the function of distribution is to ensure that your product is easily and effectively moved from the point of production to the target market, the kind of transportation system to employ e.g. Road, rail, water or air, and ensures that the product can be easily accessed by customers. You as a Marketer should also design the kind of middlemen to engage in the channel of distribution, their incentives and motivations etc.

(9) Risk bearing function: the process of moving a finished product from the point of production to the point of consumptions is characterized with lots of risks, such risks as in product damaging, pilferage and defaults etc. So you must provide effective packaging system to protect your product, good warehouse for the storage of your product until they are needed, effective transportation system to speedily deliver your product on time.

(10) Financing function: financing deals with the part of marketing to providing incomes for your business. It refers to how you can raise capital to start operation and remain in business. It refers to your modes of payment for the goods and services transferred to your costumers.

(11)  After sales-service: in a more complex and technical product, you as a marketer should make provision in order to assist your customers after they have purchased your product. In terms of machines or heavy equipment product that requires installation or maintenance, most marketing organization renders such services like installing the machine or maintaining it for stipulated periods on time for free or by a little service charge.

After sales services is an effective marketing strategy to building a long lasting customer relationship, staying ahead of your competitors while making profit for your organization.

Adequate understanding of these functions enables you as a marketer to know what is required to be done to having an effective transfer of ownership between you and your costumers, creating a big picture of your business, while also making profit for your organization.

choosing a career in the field of marketing
Thinking of choosing a career in the field of marketing?. Career in marketing can be much challenging, strategic and fun, and also it’s highly rewarding for your time and efforts.

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What is a general ledger account?

 A general ledger account is an account or record used to sort and store balance sheet and income statement transactions. Examples of general ledger accounts include the asset accounts such as Cash, Accounts Receivable, Inventory, Investments, Land, and Equipment. Examples of the general ledger liability accounts include Notes Payable, Accounts Payable, Accrued Expenses Payable, and Customer Deposits. Examples of income statement accounts found in the general ledger include Sales, Service Fee Revenues, Salaries Expense, Rent Expense, Advertising Expense, Interest Expense, and Loss on Disposal of Assets.

 Some general ledger accounts are summary records which are referred to as control accounts. The detail that supports each of the control accounts will be found outside of the general ledger in what is known as a subsidiary ledger. For example, Accounts Receivable could be a control account in the general ledger, and there will be a subsidiary ledger which contains each customer's credit activity. The general ledger accounts Inventory, Equipment, and Accounts Payable could also be control accounts and for each there will be a subsidiary ledger containing the supporting detail.

 A listing of a company's general ledger accounts is found in its Chart of Accounts.

Introduction to Debits and Credits

If the words "debits" and "credits" sound like a foreign language to you, you are more perceptive than you realize—"debits" and "credits" are words that have been traced back five hundred years to a document describing today's double-entry accounting system.

Under the double-entry system every business transaction is recorded in at least two accounts. One account will receive a "debit" entry, meaning the amount will be entered on the left side of that account. Another account will receive a "credit" entry, meaning the amount will be entered on the right side of that account. The initial challenge with double-entry is to know which account should be debited and which account should be credited.

Before we explain and illustrate the debits and credits in accounting and bookkeeping, we will discuss the accounts in which the debits and credits will be entered or posted.

What Is An Account?

To keep a company's financial data organized, accountants developed a system that sorts transactions into records called accounts. When a company's accounting system is set up, the accounts most likely to be

affected by the company's transactions are identified and listed out. This list is referred to as the company's chart of accounts. Depending on the size of a company and the complexity of its business operations, the

chart of accounts may list as few as thirty accounts or as many as thousands. A company has the flexibility of tailoring its chart of accounts to best meet its needs.

Within the chart of accounts the balance sheet accounts are listed first, followed by the income statement accounts. In other words, the accounts are organized in the chart of accounts as follows:

Assets

Liabilities

Owner's (Stockholders') Equity

Revenues or Income

Expenses

Gains

Losses

Click here to see a sample chart of accounts.

Double-Entry Accounting

Because every business transaction affects at least two accounts, our accounting system is known as a double-entry system. (You can refer to the company's chart of accounts to select the proper accounts.

Accounts may be added to the chart of accounts when an appropriate account cannot be found.)

For example, when a company borrows $1,000 from a bank, the transaction will affect the company's Cash

account and the company's Notes Payable account. When the company repays the bank loan, the Cash

account and the Notes Payable account are also involved.

If a company buys supplies for cash, its Supplies account and its Cash account will be affected. If the company

buys supplies on credit, the accounts involved are Supplies and Accounts Payable.

If a company pays the rent for the current month, Rent Expense and Cash are the two accounts involved. If a

company provides a service and gives the client 30 days in which to pay, the company's Service Revenues

account and Accounts Receivable are affected.

Although the system is referred to as double-entry, a transaction may involve more than two accounts. An example of a transaction that involves three accounts is a company's loan payment to its bank of $300. This transaction will involve the following accounts: Cash, Notes Payable, and Interest Expense.

(If you use accounting software you may not actually see that two or more accounts are being affected due to the user-friendly nature of the software. For example, let's say that you write a company check by means of your accounting software. Your software automatically reduces your Cash account and prompts you only for the other accounts affected.)

Special Feature Review what you are learning by working the three interactive crossword puzzles dedicated to this topic. They are completely free.

Click here for the Debits and Credits Crossword Puzzles

Debits and Credits

After you have identified the two or more accounts involved in a business transaction, you must debit at least one account and credit at least one account.

To debit an account means to enter an amount on the left side of the account. To credit an account means to enter an amount on the right side of an account.

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How do you write off a bad account?

 There are two ways to write off a bad account receivable. One is the direct write-off method and the other occurs under the allowance method.

 Under the direct write-off method a company writes off a bad account receivable after the specific account is found to be uncollectible. This write off usually occurs many months after the account receivable and the credit sale were recorded. The entry to write off the bad account will consist of 1) a credit to Accounts Receivable in order to remove the amount that will not be collected, and 2) a debit to Bad Debts Expense to report the amount of the loss on the company's income statement.

 Under the allowance method a company anticipates that some of its credit sales and accounts receivable will not be collected. In other words, without knowing the specific accounts that will become uncollectible, the company debits Bad Debts Expense and credits Allowance for Doubtful Accounts. This Allowance account is a contra receivable account and it allows the company to report the net amount of the receivables that it expects will be turning to cash prior to identifying and removing a specific account receivable. When a specific customer's account does present itself as uncollectible, the customer's account will be written off by crediting Accounts Receivable and debiting Allowance for Doubtful Accounts.

 In the U.S. the direct write-off method is required for income tax purposes. However, for financial reporting purposes the allowance method means recognizing the loss (the bad debts expense) closer to the time of the credit sales. As a result, the allowance method is more in line with the accountants' concept of conservatism and may result in a better matching of the bad debt expense with the credit sales.

What is a trade discount?

 A trade discount is a reduction to the published price of a product. For example, a high-volume wholesaler might be entitled to a 40% trade discount, while a medium-volume wholesaler is given a 30% trade discount. A retail customer will receive no trade discount and will have to pay the published or list price. The use of trade discounts allows for having just one published price for each product.

 The sale and purchase will be recorded at the amount after the trade discount is subtracted. For example, when goods with list prices totaling $1,000 are sold to a wholesale customer entitled to a 30% trade discount, both the seller and the buyer will record the transaction at the net amount of $700.

 Trade discounts are different from early-payment discounts. (Early-payment discounts of 1% or 2% are likely to be recorded by the seller as a sales discount and by the buyer using the periodic inventory method as a purchase discount.)

Introduction to Accounts Receivable and Bad Debts Expense

If we imagine buying something, such as groceries, it's easy to picture ourselves standing at the checkout, writing out a personal check, and taking possession of the goods. It's a simple transaction—we exchange our money for the store's groceries.

In the world of business, however, many companies must be willing to sell their goods (or services) on credit. This would be equivalent to the grocer transferring ownership of the groceries to you, issuing a sales invoice, and allowing you to pay for the groceries at a later date.

Whenever a seller decides to offer its goods or services on credit, two things happen: (1) the seller boosts its potential to increase revenues since many buyers appreciate the convenience and efficiency of making purchases on credit, and (2) the seller opens itself up to potential losses if its customers do not pay the sales invoice amount when it becomes due.

Under the accrual basis of accounting (which we will be using throughout our discussion) a sale on credit will:

Increase sales or sales revenues, which are reported on the income statement, and

Increase the amount due from customers, which is reported as accounts receivable—an asset reported on the balance sheet.

If a buyer does not pay the amount it owes, the seller will report:

A credit loss or bad debts expense on its income statement, and

A reduction of accounts receivable on its balance sheet.

With respect to financial statements, the seller should report its estimated credit losses as soon as possible using the allowance method. For income tax purposes, however, losses are reported at a later date through the use of the direct write-off method.

Recording Services Provided on Credit

Assume that on June 3, Malloy Design Co. provides $4,000 of graphic design service to one of its clients with credit terms of net 30 days. (Providing services with credit terms is also referred to as providing services on account.)

Under the accrual basis of accounting, revenues are considered earned at the time when the services are provided. This means that on June 3 Malloy will record the revenues it earned, even though Malloy will not receive the $4,000 until July. Below are the accounts affected on June 3, the day the service transaction was completed:

In this transaction, the debit to Accounts Receivable increases Malloy's current assets, total assets, working capital, and stockholders' (or owner's) equity—all of which are reported on its balance sheet. The credit to Service Revenues will increase Malloy's revenues and net income—both of which are reported on its income statement.

Introduction to Income Statement

The income statement is one of the major financial statements used by accountants and business owners. (The other major financial statements are the balance sheet,

statement of cash flows, and the

statement of stockholders' equity.) The income statement is sometimes referred to as the profit and loss

statement (P&L), statement of operations, or statement of income. We will use income statement and profit and loss statement throughout this explanation.

The income statement is important because it shows the profitability of a company during the time interval specified in its heading. The period of time that the statement covers is chosen by the business and will vary. For example, the heading may state:

"For the Three Months Ended December 31, 2012" (The period of October 1 through December 31, 2012.)

"The Four Weeks Ended December 27, 2012" (The period of November 29 through December 27, 2012.)

"The Fiscal Year Ended June 30, 2013" (The period of July 1, 2012 through June 30, 2013.)

Keep in mind that the income statement shows revenues, expenses, gains, and losses; it does not show cash receipts (money you receive) nor cash disbursements (money you pay out).

People pay attention to the profitability of a company for many reasons. For example, if a company was not able to operate profitably—the bottom line of the income statement indicates a net loss—a banker/lender/creditor

may be hesitant to extend additional credit to the company. On the other hand, a company that has operated profitably—the bottom line of the income statement indicates a net income—demonstrated its ability to use

borrowed and invested funds in a successful manner. A company's ability to operate profitably is important to current lenders and investors, potential lenders and investors, company management, competitors, government agencies, labor unions, and others.

The format of the income statement or the profit and loss statement will vary according to the complexity of the business activities. However, most companies will have the following elements in their income statements:

A. Revenues and Gains

1. Revenues from primary activities

2. Revenues or income from secondary activities

3. Gains (e.g., gain on the sale of long-term assets, gain on lawsuits)

B. Expenses and Losses

1. Expenses involved in primary activities

2. Expenses from secondary activities

3. Losses (e.g., loss on the sale of long-term assets, loss on lawsuits)

If the net amount of revenues and gains minus expenses and losses is positive, the bottom line of the profit and loss statement is labeled as net income. If the net amount (or bottom line) is negative, there is a net loss.

A. Revenues and Gains

1. Revenues from primary activities are often referred to as operating revenues. The primary activities of a retailer are purchasing merchandise and selling the merchandise. The primary activities of a manufacturer are producing the products and selling them. For retailers, manufacturers, wholesalers, and distributors the revenues resulting from their primary activities are referred to as sales revenues or sales. The primary activities of a company that provides services involve acquiring expertise and selling that expertise to clients. For companies providing services, the revenues from their primary services are referred to as service revenues or fees earned. (Some people use the word income interchangeably with revenues.)

It's critical that you don't confuse revenues with receipts. Under the

accrual basis of accounting, service

revenues and sales revenues are shown at the top of the income statement in the period they are earned or delivered, not in the period when the cash is collected. Put simply, revenues occur when money is earned, receipts occur when cash is received.

For example, if a retailer gives customers 30 days to pay, revenues occur (and are reported) when the merchandise is sold to the buyer, not when the cash is received 30 days later. If merchandise is sold in

December, the sale is reported on the December income statement. When the retailer receives the check in January for the December sale, the retailer has a January receipt—not January revenues.

Similarly, if a consulting company asks clients to pay within 30 days of receiving their service, revenues occur (and are reported) when the service is performed (earned), not 30 days later when the consulting company receives the cash from the client.

If an attorney requires a client to prepay $1,000 before beginning to research the client's case, the attorney has a receipt, but does not have revenues until some of the research is done.

If a company sells an item to a buyer who immediately pays for it with cash, the company has both a receipt and revenues for that day—it has a cash receipt because it received cash; it has sales revenues because it sold merchandise.

By knowing the difference between receipts and revenues, we make certain that revenues from a transaction are reported only once—when the primary activities have been completed (and not necessarily when the cash is collected).

Let's reinforce the distinction between revenues and receipts with a few more examples. (Keep in mind that all of the examples below assume the accrual basis of accounting.)

A company borrows $10,000 from its bank by signing a promissory note due in 90 days. The company

will have a receipt of $10,000 at the time of the loan, but it does not have revenues because it did not earn the money from performing a service or from a sale of merchandise.

If a company provided a $1,000 service on January 31 and gave the customer until March 10 to pay for the service, the company's January income statement will show revenues of $1,000. When the money is actually received in March, the March income statement will not show revenues for this transaction. (In March the company will report a receipt of cash and a reduction/collection of an accounts receivable.)

A company performs a $400 service on December 31 and receives the $400 on the very same day (December 31). This company will report $400 in revenues on December 31—not because the company had a cash receipt on December 31, but because the service was performed (earned) on that day.

On December 10, a new client asks your consulting company to provide a $2,500 service in January. You are uncertain as to whether or not this client is credit worthy, so to be on the safe side you ask for an immediate partial payment of $1,000 before you agree to schedule the work for January. Although your consulting company has a receipt of $1,000 in December, it does not have revenues in December. (In December your company will record a liability of $1,000.) Your consulting company will report the $1,000 of revenues when it performs $1,000 of services in January.

2. Revenues from secondary activities are often referred to as nonoperating revenues. These are the amounts a business earns outside of purchasing and selling goods and services. For example, when a retail business earns interest on some of its idle cash, or earns rent from some vacant space, these revenues result from an activity outside of buying and selling merchandise. As a result the revenues are reported on the income statement separate from its primary activity of sales or service revenues.

As is true with operating revenues, nonoperating revenues are reported on the profit and loss statement during the period when they are earned, not when the cash is collected.

Here's a Tip

Don't confuse revenues with receipts—

Revenues (operating and nonoperating) occur when a sale is made or when they are earned. Revenues are frequently earned and reported on the income statement prior to receiving the cash.

Receipts occur when cash is received/collected.

3. Gains such as the gain on the sale of long-term assets, or lawsuits result from a transaction that is outside of the primary activities of most businesses. A gain is reported on the income statement as the net of two amounts: the proceeds received from the sale of a long-term asset minus the amount listed for that item on the company's books (book value). A gain occurs when the proceeds are more than the book value.

Consider this example: Assume that a clothing retailer decides to dispose of the company's car and sells it for $6,000. The $6,000 received for the car (the proceeds from the disposal of the car) will not be included with sales revenues since the account Sales is used only for the sale of merchandise. Since this retailer is not in the business of buying and selling cars, the sale of the car is outside of the retailer's primary activities. Over the years, the cost of the car was being depreciated on the company's accounting records and as a result, the money received for the car ($6,000) was greater than the net amount shown for the car on the accounting records ($3,500). This means that the company must report a gain equal to the amount of the difference—in this case, the gain is reported as $2,500. This gain should not be reported as sales revenues, nor should it be shown as part of the merchandiser's primary activities. Instead, the gain will appear in a section on the income statement labeled as "nonoperating gains" or "other income". The gain is reported in the period when the disposal occurred.

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