So this is part three of our introduction to financial accounting
terms, principles, and the accounting equation. In this part we'll be covering
the revenue recognition and the matching principles. So the first one we'll look
at is the revenue recognition principle. As we all know earning revenue is the
purpose of doing business, and revenues are created by doing the day-to-day
activities that our business was created to do. What the revenue recognition
principle says is we should record revenues when they are earned not
necessarily when cash is received. Now I have necessarily in italics here because
you can earn revenue at the same time you are given the cash for performing a
service or selling a product. So just remember that revenues are recorded when
they are earned and not necessarily when cash is received. So let's look at an
example, where we earned revenues of $5,500. We're going to look at it two
different ways. The first way we're going to say okay let's say we earned these
revenues and cash was received immediately when those revenues were
earned, and then the second way we'll look at it is we earn them on account,
and we'll receive the cash later. Let's go to
number one, and so we earn these revenues and receive the cash. So how would that
affect our accounting equation? So first let's recall our accounting
equation: assets equal liabilities plus owner's equity, and let's determine what
parts of the accounting equation are getting affected here. Well, we're
receiving cash. Cash is an asset. So assets are going up by the $5,500. What
else is happening? Are we incurring a liability here? No, we're earning
revenue. So what we have to remember well revenues affect net income by increasing
net income. Net income affects retained earnings and retained earnings falls
under the owner's equity section. Therefore, revenues will make retained
earnings go up, thereby making owner's equity increase by $5,500.
And now our accounting equation balances. Let's look at the
other scenario. We earn the revenues on account , which means we'll get paid later.
So let's think again how this will affect the accounting equation? Are
our assets being affected? Well cash isn't being affected here, so earning it
on account, but there is an asset being affected and it's called accounts
receivable. Money that we are owed. So our assets are going up by the same amount
$5,500. Are our liabilities changing? We don't owe
anyone money. We earned revenue here. Again owner's equity is increasing
because our revenues are increasing. Again revenues affect net income, net
income affects retained earnings, and retained earnings is an owner's equity
account. Let's look at the second principle: incurring of expenses. Expenses
as we know create revenues. You've heard the old saying you have to spend money
to make money. Well what the matching principle tells us is that expenses are
recorded when they are incurred not necessarily when cash is paid. So again I
put necessarily here in italics because we could incur an expense and pay it
immediately. So expenses are recorded when incurred not necessarily when cash
is received. So let's look at another example. We incurred rent expense of
$16, 500. And again we'll look at two scenarios.
We paid cash immediately when the when the rent was incurred or we got the bill
and we're going to pay it later. So the first one else is cash, we paid it
immediately. How does that affect the accounting equation? Well does it affect
assets? If we pay something it affects cash. Cash is an asset. So
assets are going down by the $16,500. Our liability is affected. We're not
incurring the liability here. We don't owe someone money in this case because
we're paying this bill immediately. So it doesn't affect liabilities. Well what
about owner's equity? We're incurring an expense.
Recall that expenses decrease net income, so they affect net income, and net income
affects retained earnings, and retained earnings is found under the owner's
equity section of our accounting equation. So owner's equity is decreasing
by that $16,500. Now let's look at the scenario under incurring it on an
account. So let's see how that will affect our accounting equation. So again
our assets being affected in this case.
Let's look at this scenario as if it's happening right now.
Assets are not being affected, however, we owe this money. We're going to owe this
money in the future. So for right now liabilities are increasing. We owe that
money. What else is happening? Well owner's equity is still going down
because we're incurring an expense, and expenses decreased net income, net income
affects retained earnings and retained earnings, as part of owner's equity. So
it's making owner's equity go down and even though nothing happened on the
left-hand side of the accounting equation we still balance. There was no
change to the accounting equation at all because the right side went up by
$16,500 and it went down by $16,500.
So there's no change there. Well if this is what
today right now, what will happen in the future when we pay this bill or pay off
this rent expense? So let's look at what will happen in the future? Will assets be
affected? When we pay out money, cash is affected. Cash that's an asset so
assets will go down by that $16,500. Is
liabilities affected? Yes, we no longer owe that debt because we're paying it off.
So our liabilities are also going down by $16,500,
and owner's equity is not being affected here because we're just paying off a
debt. And as you can see our accounting equation still balances.