I have laid down some basics about the four financial statements in previous posts, and in this posts we are going to look at how these four financial statements interconnect and the details and subtleties in constructing these statements. The accuracy of these details are extremely important, because false statements are fraud and may inflict very serious consequences to the company.
First thing we will look at is how we report revenues and expenses in income statements. We don’t always make payments upfront. Sometimes purchases or sales are made, but cash hasn’t been paid. Do we recognize these transactions in the income statements?
The Revenue Recognition Principle and Matching Principle say yes.
Revenue Recognition Principle: recognize revenues when earned.
Matching Principle: recognize expenses when incurred.
In other words, the value of all the work that has been done (sale of products and services) shall be reported, and all the expenses spent for the work done shall also be reported. Therefore, if Mercedes sells a car to a customer who’s going to pay overtime, the total revenue of the sale is recognized in the income statement, because Mercedes has already sold the car and there’s no more obligated work to be done on that car by Mercedes. Similarly, the wages for the salespeople on that car should also be included in the expenses section of the income statement now, even if Mercedes won’t pay them until the end of the month. That is because the salespeople have done their work on selling the car and their share of the reward from selling that car is considered paid.
Adjustment is the process of fixing the financial statements after the delayed payments are made. There are four types of adjustments, two of which we will discuss today:
Unearned revenues are cash received from customers before goods and services are (fully) provided; an example would be a yearly subscription fee of a magazine or the reservation fee of a famous restaurant. If a customer paid 100 dollars to subscribe the Westonian magazine in the beginning of the year, there would be a plus 100 in the cash asset section of the balance sheet, because Westonian magazine receives their subscription fees in the beginning of the year. There would also be a plus 100 in the liabilities section, because now the Westonian magazine owes the customers 100 dollars worth of magazine content through the year. There’s no change in the income statement because the magazines hasn’t been edited and produced, no work has been done. When the end of the year comes, and the customer has received and read every issue of the Westonian magazine, there will be a 100 reduction from the liabilities section of the balance sheet, because the Westonian Magazine no longer owes this customer any more magazine contents. There will be a plus 100 in the earned capital section of the balance sheet, because the 100 dollars has been earned and is now capital that the Westonian magazine owns. There will be a plus 100 in the revenue section and the net income of the income statement, because the work that earned the 100 dollars has been done. The revenue is recognized.
Prepaid expenses are cash paid in advance that will later become expenses after its generated its value, an example would be office rentals. If the Westonian magazine paid 3000 dollars for a 3 year rent of its current office, a minus 3000 in the cash asset and a plus 3000 in the noncash asset is reflected on the balance sheet. The total cash Westonian owns is reduced by 3000 dollars due to this payment, but it also earns the usage of this office space for three years which is worth 3000 dollars. Nothing is reflected on the income statement yet, because no revenue has been generated from this office space yet. At the end of the first year, Westonian magazine has done a year worth of work, there will be a minus 1000 in the non-cash asset section and the earned-capital section of the balance sheet, because now Westonian magazine only owns two years’ usage of the office space. There will also be a minus 1000 in net income and plus 1000 in expenses in the income statement, because Westonian has generated its revenue in the office space, and the cost of generating that revenue is the 1000 dollars-worth of one year usage of this office space. The expense is matched with its revenue.