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Working with Financial Statements
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Working with Financial Statements
Accounting principles and concepts refer to the broad concepts devised to provide accountants with basic frameworks for preparing financial statements. Their aim is to guide the application of accounting practices and policies applied by accountants to make sure that the users of financial information are not mislead (Marriott, Edwards & Mellett, 2002). In this essay, the expense and revenue recognition principles will be explained. Furthermore, some transactions that require adjustments of journal entries will be explained and illustrated.
Revenue and Expenses Recognition Principles
Revenue recognition principle, also referred to as the realization concept, involves the application of accrual concept, alongside matching concept, in recording revenue. In accounting, revenue refers to the income that is received from the normal activities of a business, and it may arise from the sale of either goods or services. Therefore, revenue, due to its significance, needs to be well recognized in financial statements. The principle holds that in case of goods, revenue is recognized once the rewards and risks associated with the goods are transferred from the seller to the buyer, irrespective of whether the buyer has paid for them or not. In case of rendering services, the seller recognizes revenue once the delivery of the service is completed, and where service delivery is in the form of a contract, revenue is recognized once the part of a contract is completed. This principle ensures that only the actual revenue that is earned during a financial period is reflected in the income statement (Larson, Kalagnanam & Jensen, 2005).
Expense recognition principle, on the other hand, involves the conversion of an organization’s assets into expenses. Expenses refer to the liabilities incurred or an outflow of assets from a business. This principle provides that expenses should be recognized based on the matching concept, which holds that both revenues and expenses should be recognized simultaneously. This means that expenses are recognized when they contribute to the earning of revenue. Moreover, expenses are recorded for the period, during which they are incurred. However, not all expenses can be directly linked to revenue, for instance, depreciation. This calls for the application of other systematic and rational approaches in their recognition. Such expenses are recognized for the financial periods that they are incurred. The conceptual framework provides that expenses should be recognized immediately, when an increase in liability or reduction in assets results to reduction of future economic benefits (Larson, Kalagnanam & Jensen, 2005).
Situations that Require Adjusting of Journal Entries
Prepaid Expenses
A prepaid expense refers to an expense that has been paid in advance, and which has not been incurred yet. Since expenses are recognized in the financial period in which they are incurred, prepaid expenses should not be recognized during the period the customer pays for them. Instead, prepayments are recorded as assets and disclosed in the balance sheet as assets, during the period they are paid for. However, once they are due, journal entry adjustments are performed to recognize them as expenses (Marriott, Edwards & Mellett, 2002).
Example. On 31 December, 2013, XYZ Ltd paid in advance $1,000 in respect of factory rent for January 2014. Given that XYZ’s financial period ends on December 31, the company will recognize the prepaid amount as an asset when it is paid (December 31). During the 2014 financial year, the $1,000 will be recognized as an expense with after performance of some journal entries. The accounting treatment of this example is as below.
Dec 31, 2013 cash a/c
Prepaid rental expense a/c $ 12,000
$ 12,000
Jan 31, 2014 prepaid rental income a/c
Rental income a/c $ 12,000
$ 12,000
Dec 31, 2014 Rental income a/c
Income statement a/c $ 12,000
$ 12,000

Unearned Revenues
This refers to the receipt of cash for goods or services before their delivery to the customer. Since revenue is recognized when the goods or services are delivered to a client, such revenue is termed as ‘unearned’, and it is recognized as a liability. A liability is a responsibility that arises from a past event, and which will result in an outflow of economic benefits in the future. When a liability expires, after an outflow of resources, it converts to an asset. Therefore, unearned revenue is not recognized as income until the goods or services are delivered to the customer, which results in the conversion of a liability to an asset (Marriott, Edwards & Mellett, 2002).
Example. On 1 December, 2013, XYZ Ltd receives $1000 in advance from a client in respect of rental income for the month of January 2014. In accounting, the transaction is recorded as follows.
Dec 12, 2013 cash a/c
Unearned rental income a/c $ 12,000
$ 12,000
Jan 31, 2014 Unearned rental income a/c
Rental income a/c $ 12,000
$ 12,000
Dec 31, 2014 Rental income a/c
Income statement a/c $ 12,000
$ 12,000

Unpaid Expense
This refers to an expense that has not been paid for, yet it has been incurred. In this case, the accrued expense is recognized and charged to the income period for which it is incurred, since expenses are recognized in the period they are incurred, rather than when they are paid for (Marriott, Edwards & Mellett, 2002).
Example. XYZ Ltd, the accounting period of which ends on 31 December, paid $1,000 rental expense for the month of December on 4 January, 2014. Below are the journal entries of the transaction.
Dec 31, 2013 Rent expense a/c
Accounts payable a/c $ 12,000
$ 12,000
Dec 31, 2013 income statement a/c
Rent expense a/c $ 12,000
$ 12,000
Jan 4, 2014 accounts payable a/c
Cash a/c $ 12,000
$ 12,000

Accrued Revenue
This refers to the revenue that despite having been earned, has not yet been paid for by the customer. Once the revenue is earned, and it has not yet been paid, it is recognized as income and disclosed in the income statement during the year that it is earned. The accrued revenue account is credited in the income statement to recognize revenue, and debited in the balance sheet to recognize an asset. On the receipt of the payment, relevant journal entries are performed (Marriott, Edwards & Mellett, 2002).
Example. On 10 January, 2014, XYZ Ltd received $1,000 rental income for the month of 31 December, 2013, from a tenant. The accounting treatment of this example will be as follows.
Dec 31 accounts receivable a/c
Rental income a/c $ 12,000
$ 12,000
Dec 31 Rental income a/c
Income statement a/c $ 12,000
$ 12,000
Jan 10 cash a/c
Accounts receivable a/c $ 12,000
$ 12,000

References
Larson, K. D., Kalagnanam, S. S., & Jensen, T. (2005). Fundamental accounting principles. Toronto: McGraw-Hill Ryerson.
Marriott, P., Edwards, J. R., & Mellett, H. (2002). Introduction to accounting. London: SAGE.