Difficulty: Introductory | Prerequisites: Financial Accounting Foundations (Part 1 of these notes)
This set of notes covers how businesses measure their performance over a period of time through the income statement, and the rules that govern when revenues and expenses are recognised. It builds directly on the accounting equation and journal entries from Part 1. Understanding accrual accounting is essential because it is the method required by GAAP, and nearly every exam question about revenue or expense timing relies on it.
The income statement separates operating activities (core business) from non-operating items (incidental gains, losses, interest). Under accrual accounting, revenue is recognised when earned and expenses when incurred, regardless of when cash changes hands. Prepaid expenses start as assets and become expenses over time; unearned revenues start as liabilities and become revenue when the obligation is fulfilled.
Revenue
An increase in assets or settlement of liabilities from the business's core operations (e.g., sales revenue). Think of it as the money the business earns by doing what it exists to do.
Expense
A decrease in assets or increase in liabilities incurred to generate revenue (e.g., wages, rent, utilities). In simple terms, these are the costs of running the business.
Gain
An increase from an incidental or peripheral transaction, outside the company's main operations (e.g., selling old equipment for more than its book value).
Loss
A decrease from an incidental or peripheral transaction (e.g., selling old equipment for less than its book value).
Operating revenues
Earnings from the primary business activities. For a retailer, this is sales revenue.
Operating expenses
Costs directly tied to generating operating revenues: wages, rent, utilities, supplies, depreciation of operating assets.
Non-operating items
Interest revenue, interest expense, and gains or losses from activities outside the core business. Reported separately on the income statement to give a clearer picture of how the core business is performing.
Classified income statement
An income statement that separates operating items from non-operating items. This layout helps users assess whether profits come from the company's main activities or from one-off events.
Cash basis of accounting
Revenues and expenses are recognised only when cash is received or paid. Simple, but can misrepresent the true financial position. Not permitted under GAAP for most businesses.
Accrual basis of accounting
Revenues are recognised when earned, and expenses when incurred, regardless of when cash moves. Required by GAAP. Think of it as: record the economic event, not the cash event.
Revenue recognition principle
Revenue is recognised when the company has satisfied its performance obligation by delivering goods or services. The trigger is delivery, not payment.
Matching principle (expense recognition principle)
Expenses are recognised in the same period as the revenues they help generate. This pairs costs with the income they produce, giving an accurate picture of profitability for each period.
Prepaid expenses (prepayments)
Payments made in advance for benefits to be received later (e.g., prepaid rent, prepaid insurance). Initially recorded as assets, then expensed over time as the benefit is consumed.
Unearned revenues (deferred revenues)
Cash received before the business has delivered goods or services (e.g., gift cards, advance ticket sales). Recorded as a liability until the obligation is fulfilled, then recognised as revenue. Think of it as: the company owes the customer something.
Cost of goods sold (COGS)
The original cost of inventory that has been sold to customers. Matched against sales revenue to calculate gross profit.
Net profit margin
Net Income divided by Net Sales. Measures how much profit remains from each pound or dollar of sales after all expenses. A key indicator of operational efficiency.
Operating cycle
The time it takes to purchase inventory, sell it, and collect cash. Usually one year or less. This cycle determines the boundary between current and non-current classifications.
Periodicity assumption (time period assumption)
Business activities can be divided into artificial but useful time periods (months, quarters, years) for reporting purposes.
Monetary unit assumption
All transactions are measured and reported in a single monetary unit (e.g., dollars). Non-monetary events are not recorded.
Going concern assumption
The assumption that the business will continue operating indefinitely, rather than being liquidated in the near future. This underpins the logic of spreading costs over multiple periods.
Organises revenues and expenses into operating and non-operating sections.
Operating section: sales revenue minus operating expenses (wages, rent, utilities, depreciation) = operating income.
Non-operating section: interest revenue, interest expense, gains and losses from incidental transactions.
Separating the two lets users see whether the core business is profitable on its own, apart from one-off events.
The operating cycle runs from purchasing inventory, to selling goods or services, to collecting cash. For most businesses this takes a year or less.
Three key assumptions underpin financial reporting:
Monetary unit: everything is measured in a single currency.
Going concern: the business is expected to continue indefinitely.
Periodicity: the life of the business is divided into reporting periods (months, quarters, years) so that performance can be measured at regular intervals.
Revenues increase net income. They arise when assets increase or liabilities are settled through core operations.
Expenses decrease net income. They arise when assets are consumed or liabilities are incurred to generate revenue.
Gains and losses also affect net income but are reported separately because they come from peripheral activities.
Cash basis: record revenue when cash is received, record expenses when cash is paid. Simple, but can paint a misleading picture. A company could perform $50,000 of services in December and receive payment in January; under cash basis, December shows no revenue.
Accrual basis: record revenue when earned (goods delivered or services performed), record expenses when incurred (the cost is consumed or the obligation arises), regardless of cash timing. Required by GAAP.
The accrual basis matches economic reality to the correct period.
Revenue is recognised when the company satisfies its performance obligation by delivering goods or services to the customer.
The key trigger is the transfer of goods or completion of service, not the receipt of cash.
Example: a consulting firm completes a project in March but does not receive payment until April. The revenue belongs in March.
Expenses are recognised in the same period as the revenues they help generate.
If a company earns revenue from selling a product in June, the cost of that product (COGS) is recorded in June, even if the supplier was paid in May.
This approach ensures each period's income statement reflects a realistic picture of profitability.
A prepaid expense is cash paid in advance for a future benefit (e.g., six months of insurance paid upfront).
Initially recorded as an asset (Prepaid Insurance).
As time passes and the benefit is consumed, a portion is moved from the asset to an expense (Insurance Expense) through an adjusting entry.
Example: pay $6,000 for six months of insurance on 1 January. Each month, $1,000 moves from Prepaid Insurance (asset decreases) to Insurance Expense (expense increases).
Cash received before the company has delivered the goods or services.
Initially recorded as a liability (Unearned Revenue) because the company owes the customer something.
As the obligation is fulfilled, the liability decreases and revenue is recognised.
Example: a gym sells a $1,200 annual membership on 1 January. Each month, $100 moves from Unearned Revenue (liability decreases) to Membership Revenue (revenue increases).
When goods are sold, two entries are typically made:
Sales revenue is recognised (debit Accounts Receivable or Cash, credit Sales Revenue).
Cost of goods sold is recorded (debit COGS, credit Inventory).
Gross profit = Sales Revenue minus COGS. This is the profit before operating expenses are deducted.
Measures overall profitability: Net Income / Net Sales.
A higher margin means the company retains more profit from each unit of revenue.
Useful for comparing companies of different sizes within the same industry.
\text{Net Profit Margin} = \frac{\text{Net Income}}{\text{Net Sales}}Expressed as a percentage. A net profit margin of 0.15 means the company keeps 15p (or 15 cents) of profit for every pound (or dollar) of sales after all expenses.
\text{Gross Profit} = \text{Sales Revenue} - \text{Cost of Goods Sold}Gross profit measures how much remains after covering the direct cost of the goods sold, before operating expenses such as rent and wages are deducted.
Gift cards are a textbook example of unearned revenue. When a customer buys a $50 gift card, the retailer records a $50 liability. Revenue is recognised only when the customer redeems the card. This is why retailers report large unearned revenue balances on their balance sheets around the holiday season.
Subscription businesses (software, streaming, magazines) rely heavily on the revenue recognition principle. A customer pays $120 upfront for a 12-month subscription; the company recognises $10 of revenue each month as the service is delivered.
Students often think cash received always equals revenue earned. Under accrual accounting, these are different events. Cash can arrive before, after, or at the same time as revenue recognition.
Students sometimes classify all expenses as operating. Interest expense, for instance, is a non-operating item because it relates to financing, not core business activities.
Students sometimes think prepaid expenses are expenses from day one. They are not. A prepaid expense starts as an asset and only becomes an expense as the benefit is consumed.
Students often forget that COGS must be matched against the revenue from that specific sale, in the same period. Buying inventory is not an expense; selling it is.
Expect questions that give you a cash transaction and ask you when the revenue or expense should be recognised under accrual accounting. The answer is almost never "when cash changes hands."
Know how to journalise a prepaid expense at the point of payment and the subsequent adjusting entry.
Know how to journalise unearned revenue at the point of receipt and the subsequent adjusting entry when the obligation is fulfilled.
The difference between operating and non-operating items on the income statement is frequently tested. Interest expense is always non-operating.
Net profit margin calculations are common. Be comfortable calculating it and interpreting what the result means.
True or False: Under the cash basis of accounting, revenue is recorded when goods are delivered.
Fill in the blank: Prepaid expenses are initially recorded as __________ on the balance sheet.
True or False: Interest expense is classified as an operating expense on the classified income statement.
Fill in the blank: Gross Profit = Sales Revenue minus __________.
True or False: Unearned revenue is a liability.
Answers: 1. False (cash basis records revenue when cash is received). 2. Assets. 3. False (it is non-operating). 4. Cost of Goods Sold (COGS). 5. True.
Q: A company performs $3,000 of consulting services in November but does not receive payment until December. Under accrual accounting, when is the revenue recognised?
A: November, when the service was performed and the performance obligation was satisfied. The cash receipt in December does not determine when revenue is recognised.
Q: On 1 October, a company pays $2,400 for 12 months of insurance. What is the adjusting entry on 31 December?
A: Three months of insurance have been consumed (October, November, December). Debit Insurance Expense $600, credit Prepaid Insurance $600.
Q: A magazine publisher receives $360 on 1 January for a 12-month subscription. How much revenue is recognised by 31 March?
A: $90 (three months at $30 per month). The adjusting entry each month debits Unearned Revenue $30 and credits Subscription Revenue $30.
Q: A company has net income of $45,000 and net sales of $300,000. What is its net profit margin?
A: $45,000 / $300,000 = 0.15, or 15%. The company earns 15 cents of profit for every dollar of sales.
Q: Classify the following as operating or non-operating: (a) sales revenue, (b) interest expense, (c) rent expense, (d) gain on sale of equipment.
A: (a) Operating. (b) Non-operating. (c) Operating. (d) Non-operating.
The revenue recognition and matching principles directly set up the adjusting entries covered in Part 3 of these notes. Prepaid expenses and unearned revenues are the two most common categories of deferrals that require adjustment at period end. The income statement flows into the balance sheet through retained earnings: net income increases retained earnings, and dividends decrease it (covered in Part 1).
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