Cash Flows

Revenue recognition principle indicates that revenue ought to be recorded once it is realized or realizable also when it is earned. That is companies must record revenue whether it is paid or not. The revenue recognition principle ensures that the performance reported by an entity as shown in the income statement, shows the actual extent of earned revenue within a particular period rather the generated cash flows that can alternatively be evaluated within the cash flow statement. Evaluation of revenue based on cash presents an inconsistent basis of examining a company’s performance within a number of accounting periods as a result of probable cash flows volatility (Bragg, 2010). Costs are categorized into two i.e. product costs along with period costs, grounded on if they are capitalized within the products cost produced or not.

Products cost

Costs that form a component of cost of produced goods are known as product costs. These costs are incurred during the manufacturing process, that is, either indirectly as overheads or directly costs such as labor and material costs. Because the matching accounting principle indicates that expenses should be matched with revenue they create, thus it is essential to expense costs of products only once the realization of products’ sales revenue is attained.  This is accomplished through debiting costs of product to the goods manufactured costs and therefore expensed simply when sales of these products are realized.  Product costs include labor, raw material, fuel, packaging costs and factory depreciation. Products are usually further categorized into direct labor, direct material along with factory overhead  (Bragg, 2013).

Period costs are simply every other costs apart from product costs. Period costs are not usually incurred during the manufacturing processes therefore they cannot be categorized as cost of goods manufactured. These costs are thus expensed within the period that they are incurred. Period costs comprise costs such as sales commissions, advertising, office depreciation, research & development and legal costs. Period costs are further categorized as selling costs along with administrative costs.

 Matching principle necessitates that incurred expenses by a company be charged into the income statement within the period of accounting that the revenue in which the said expenses relate are earned. The matching principle application results to the deferment of prepaid expenses so as to match them to the revenue earned within the future periods (Bragg, 2013). For instance, if a frim’s sales are done by sales representatives and they earn 10% commission and that these commissions are paid on the 15^th day of the subsequent month. Thus if the firm will pay $6000 on October 15, the matching principle necessitates that the $6000 of commission be reported within September income statement together with the associated $60,000 September sales. This is maybe carried out by an adjustment entry on September 31 which debits Commission Expense along with credits Payable Commissions of $6000. Thus, the matching principle is linked to the accrual accounting method along with adjusting entries. In absence of the matching principle would report the $6,000 commission expense within October (once it is paid) rather than December once the expense along with liability are incurred.

A manufacturer’s or a retailer’s spends an amount of money to buy inventory items, that expenses is not recorded till inventory bought is sold for revenue. Additionally, only the component of the expense attributable to every item as it was sold is recorded.   

References

Bragg, S. M. (2010). Wiley revenue recognition: Rules and scenarios. Hoboken, NJ: Wiley.

Bragg, S. M. (2013). Accounting best practices. Hoboken, NJ: John Wiley & Sons.