2.05 – Pinpointing the Assets & Liabilities Used to Record Revenue & Expenses
The sales and expense activities of a business involve various assets and liabilities, not just cash. Understanding these accounts helps you grasp how profit-making activities are recorded.
Making Sales
Many businesses allow customers to buy on credit. This involves an asset account called accounts receivable. When a credit sale is made, sales revenue and accounts receivable increase. The cash is collected later, and accounts receivable decreases.
In contrast, some businesses collect cash before delivering products or services, like software subscriptions or airline tickets. These transactions increase cash and a liability account called deferred revenue. Revenue is recorded when the service or product is delivered, decreasing the liability account.
Selling Products: Inventory
For businesses that sell products, the cost of goods sold (COGS) is a primary expense. When products are purchased, their cost is recorded in an inventory asset account. Upon sale, the cost is transferred from inventory to COGS expense. This process matches the cost of goods sold with the revenue they generate, ensuring accurate profit calculation.
Prepaying Operating Costs
Prepaid expenses, like insurance or office supplies, are recorded as assets when paid. These costs are allocated as expenses over the periods they benefit. For example, if insurance is prepaid for six months, the expense is recorded monthly over that period.
Understanding Fixed Assets
Fixed assets, like buildings, machinery, and vehicles, are long-term assets used in business operations. Depreciation spreads the cost of these assets over their useful lives, charging a portion of the cost to expense each year. This ensures that each year of use bears a share of the total cost.
Figuring Unpaid Expenses
Many expenses are paid after the period they are incurred. Common examples include legal fees, retirement contributions, and utility bills. These unpaid expenses are recorded using three types of liability accounts:
- Accounts Payable: For items bought on credit and invoiced.
- Accrued Expenses Payable: For costs incurred but not yet billed, like unused vacation days or future repairs under warranty.
- Income Tax Payable: For income taxes owed but not yet paid at year-end.
Additional Insights for Understanding Revenue and Expenses
Impact on Cash Flow
Revenue and expenses often impact cash flow before or after they are recorded. For example, purchasing inventory reduces cash before it’s sold, and sales on credit increase accounts receivable before cash is collected. This means cash flow from profit activities usually differs from accounting profit.
Matching Principle
The matching principle ensures expenses are recorded in the same period as the revenue they help generate. This principle is vital for accurate profit measurement and financial reporting.
Monitoring Asset and Liability Changes
Managers need to monitor how profit activities affect assets and liabilities. Understanding these changes helps manage cash flow and financial health effectively.
By understanding the various assets and liabilities used to record revenue and expenses, you can gain a clearer picture of a business’s financial activities and performance. This knowledge is essential for accurate financial management and decision-making.
