Feature Story
What Was Your Profit?
The accuracy of the financial reporting system depends on answers to a few fundamental question : At what point has revenue been earned? At what point is the earnings process complete? When have expenses really been incurred?
During the 1990s' boom in the stock prices of dot-coms began swaping websites. To boost reported revenue, some dot-coms began swapping website and space. Company A would put an ad for its website on company B's website, and company B would put an ad for its website company A's website. No money changed hands, but each company recorded revenue (for the value of the space that it gave the other company on its site). This practice did little to boost net income, and it resulted in no additional cash flow-but it did boost reported revenue. Regulators eventually put an end to this misleading practice.
Another type of transgression result from companies recording revenues or expenses in the wrong year. In fact , shifting revenues and expenses is one of the most common abuses of financial accounting. Xerox, for example, admitted reporting billions of dollars of lease reveue in periods earlier than it should have been reported. And WorldCom stunned the financial markets with its adminission that it had boosted net income by billions of dollars by delaying the recognition of expenses until later years.
Unfortunately, revelations such as these have become all too common in the corporate world. It is no wonder that a U.S. Trust survey of affluent Americans reported that 85% of respondents believed that there should be tighter regulation of financial disclocures; 66% said they did not trust the management of publicly traded companies.
Why did so many companies violate basic financial reporting rules and sound ethics? Many speculate that as stock prices climbed, executives were under increasing pressure to meet higher earnings expectations. If actual result weren't as good as hoped for, some gave in to temptation and "adjusted" their numbers to meet market expectations.
Timing Issues
We would need to adjustments if we could wait to prepare financial statements until a company ended its operations. At that point, we could easily determined. The following story illustrates one way to compute lifetime income.
A grocery store owner from the "old country" kept his accounts payable on a spindle, accounts receivable on a note pad, and cash in a cigar box. His daughter, having just passed the CPA exam, chided the father : " I don't understand how you can run your business this way. How do you know what your profits are?"
"Well," the father replied, " when I got off the boat 40 years ago, I had nothing but the pants I was wearing. Today your brother is a doctor, your sister is a college professor, and you are a CPA. You mother and business, and everything is paid for. So, you add all that together, substract the pants, and there's your profit."
Selecting an Accounting Time Period
Although the old grocer may be correct his evaluation, it is impractical to wait so long for the results of operations. All companies find it desirable to report the results of their activities on a frequent basis. For example, management usually wants monthly financial statements, and the Internal Revenue Service requires all business to file annual tax returns. Therefore, accountants divide the economic life of a business into artifical time periods. This convenient assumption is referred to as the time period assumption.
Many business transactions affect more than one of these arbitary time periods. For example, the airplanes purchased by Northwest Air Lines five years ago are still in use today. We must determine the relevance of each business transaction to specific accounting periods. (How much of the cost of an airplane contributed to operation this year?).
Fiscal and Calendar Years
Both small and large companies prepare financial statements periodically in order to asses their financial condition and results of operations. Accounting time periods are generally a month, or a year. Monthly and quarterly time periods are called interim periods. Most large companies must prepare both quarterly and annual financial statements.
An accounting time period that is one year in length is a fiscal year. A fiscal year usually begins with the first day of a month and ends twelve months later on the last day of a month. Most businesses use the calendar year (January 1 to December 31) as their accounting peiod. Some do not. Companies whose fiscal year differs from the calendar year include Delta Air Lines, June 30, and Walt Disney Productions, September 30. Sometimes a company's year-end will vary from year to year. For example, PepsiCo's fiscal year ends on the Friday closest to December 31, which was December 25 in 2004 and December 30 in 2005.
Accrual- vs. Cash-Basic Accounting
What you will learn in this chapter is accrual-basic accounting. Under the accrual basic, companies record transactions in the periods in which the event occur. For example, using the accrual basic to determine net income means companies recognize revenues when earned (rather than when they receive cash). It also means recognizing expenses when incurred (rather than when paid).
An alternative to the accrual basis in the cash basis. Under cash-basis accounting, companies record revenue when they receive cash. They record an expense when they pay out cash. The cash basis seems appealing due to its simplicity, but it often produces misleading financial statements. It fails to record revenue that a company has earned but for which it has not received the cash. Also, it does not match expenses with earned revenues. Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP).
Individuals and some small companies do use cash-basis accounting. The cash basis is justified for smal businesses because they often have few receivables and payables. Medium and large companies use accrual-basis accounting.
Recognizing Revenues and Expenses
It can be difficult to determine the amount of revenues and expenses to report in a given accounting period. Two principles help in this task : the revenue recognition principle and the matching principle.
REVENUE RECOGNITION PRINCIPLE
The revenue recognition principle dictates that companies recognize revenue in the accounting period in which it is earned. In a service enterprise, revenue is considered to be earned at the time the service is performed. To illustrate, assume that Dave's Dry Cleaning cleans clothing on June 30 but customers do not claim and pay for their clothes until the first week of July. Under the revenue recognition principle, Dave's earns revenue in June when it performed the service, rather than in July when it received the cash. At June 30, Dave's would report a receivable on its balance sheet and revenues in its income statement for the service performed.
MATCHING PRINCIPLE
Accountants follow a simple rule in recognizing expenses : "Let the expenses follow the revenues." That is, expense recognition is tied to revenue recognition. In the dry cleaning example, this principle means that Dave's should report the salary expense incurred in performing the June 30 cleaning service in the income statement for the same period in which it recognizes the service revenue. The critical issue in expense recognition is when the expense makes its contribution to revenue. This may or may not be the same period in which the expense is paid. If Dave's does not pay the salay incurred on June 30 until July, it would report salaries payable on its June 30 balance sheet.
This practice of expense recognition is referred to as the matching principle. It dictates that efforts (expenses) be matched with accomplishments (revenues).
post by : Rony Sutiyanto
Selecting an Accounting Time Period
Although the old grocer may be correct his evaluation, it is impractical to wait so long for the results of operations. All companies find it desirable to report the results of their activities on a frequent basis. For example, management usually wants monthly financial statements, and the Internal Revenue Service requires all business to file annual tax returns. Therefore, accountants divide the economic life of a business into artifical time periods. This convenient assumption is referred to as the time period assumption.
Many business transactions affect more than one of these arbitary time periods. For example, the airplanes purchased by Northwest Air Lines five years ago are still in use today. We must determine the relevance of each business transaction to specific accounting periods. (How much of the cost of an airplane contributed to operation this year?).
Fiscal and Calendar Years
Both small and large companies prepare financial statements periodically in order to asses their financial condition and results of operations. Accounting time periods are generally a month, or a year. Monthly and quarterly time periods are called interim periods. Most large companies must prepare both quarterly and annual financial statements.
An accounting time period that is one year in length is a fiscal year. A fiscal year usually begins with the first day of a month and ends twelve months later on the last day of a month. Most businesses use the calendar year (January 1 to December 31) as their accounting peiod. Some do not. Companies whose fiscal year differs from the calendar year include Delta Air Lines, June 30, and Walt Disney Productions, September 30. Sometimes a company's year-end will vary from year to year. For example, PepsiCo's fiscal year ends on the Friday closest to December 31, which was December 25 in 2004 and December 30 in 2005.
Accrual- vs. Cash-Basic Accounting
What you will learn in this chapter is accrual-basic accounting. Under the accrual basic, companies record transactions in the periods in which the event occur. For example, using the accrual basic to determine net income means companies recognize revenues when earned (rather than when they receive cash). It also means recognizing expenses when incurred (rather than when paid).
An alternative to the accrual basis in the cash basis. Under cash-basis accounting, companies record revenue when they receive cash. They record an expense when they pay out cash. The cash basis seems appealing due to its simplicity, but it often produces misleading financial statements. It fails to record revenue that a company has earned but for which it has not received the cash. Also, it does not match expenses with earned revenues. Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP).
Individuals and some small companies do use cash-basis accounting. The cash basis is justified for smal businesses because they often have few receivables and payables. Medium and large companies use accrual-basis accounting.
Recognizing Revenues and Expenses
It can be difficult to determine the amount of revenues and expenses to report in a given accounting period. Two principles help in this task : the revenue recognition principle and the matching principle.
REVENUE RECOGNITION PRINCIPLE
The revenue recognition principle dictates that companies recognize revenue in the accounting period in which it is earned. In a service enterprise, revenue is considered to be earned at the time the service is performed. To illustrate, assume that Dave's Dry Cleaning cleans clothing on June 30 but customers do not claim and pay for their clothes until the first week of July. Under the revenue recognition principle, Dave's earns revenue in June when it performed the service, rather than in July when it received the cash. At June 30, Dave's would report a receivable on its balance sheet and revenues in its income statement for the service performed.
MATCHING PRINCIPLE
Accountants follow a simple rule in recognizing expenses : "Let the expenses follow the revenues." That is, expense recognition is tied to revenue recognition. In the dry cleaning example, this principle means that Dave's should report the salary expense incurred in performing the June 30 cleaning service in the income statement for the same period in which it recognizes the service revenue. The critical issue in expense recognition is when the expense makes its contribution to revenue. This may or may not be the same period in which the expense is paid. If Dave's does not pay the salay incurred on June 30 until July, it would report salaries payable on its June 30 balance sheet.
This practice of expense recognition is referred to as the matching principle. It dictates that efforts (expenses) be matched with accomplishments (revenues).
post by : Rony Sutiyanto
No comments:
Post a Comment