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Revenue Recognition Principle and Matching Principle - Accounting video - YouTube
Channel: Dr. Brian Routh
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So this is part three of our
introduction to financial accounting
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terms, principles, and the accounting
equation. In this part we'll be covering
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the revenue recognition and the matching
principles. So the first one we'll look
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at is the revenue recognition principle.
As we all know earning revenue is the
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purpose of doing business, and revenues
are created by doing the day-to-day
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activities that our business was created
to do. What the revenue recognition
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principle says is we should record
revenues when they are earned not
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necessarily when cash is received. Now I
have necessarily in italics here because
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you can earn revenue at the same time
you are given the cash for performing a
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service or selling a product. So just
remember that revenues are recorded when
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they are earned and not necessarily when
cash is received. So let's look at an
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example, where we earned revenues of
$5,500. We're going to look at it two
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different ways. The first way we're going
to say okay let's say we earned these
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revenues and cash was received
immediately when those revenues were
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earned, and then the second way we'll
look at it is we earn them on account,
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and we'll receive the cash later. Let's go to
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number one, and so we earn these revenues
and receive the cash. So how would that
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affect our accounting equation? So
first let's recall our accounting
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equation: assets equal liabilities plus
owner's equity, and let's determine what
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parts of the accounting equation are
getting affected here. Well, we're
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receiving cash. Cash is an asset. So
assets are going up by the $5,500. What
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else is happening?
Are we incurring a liability here? No, we're earning
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revenue. So what we have to remember well
revenues affect net income by increasing
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net income. Net income affects retained
earnings and retained earnings falls
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under the owner's equity section.
Therefore, revenues will make retained
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earnings go up, thereby making owner's
equity increase by $5,500.
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And now our accounting
equation balances. Let's look at the
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other scenario. We earn the revenues on
account , which means we'll get paid later.
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So let's think again how this
will affect the accounting equation? Are
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our assets being affected? Well cash
isn't being affected here, so earning it
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on account, but there is an asset being
affected and it's called accounts
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receivable. Money that we are owed. So our
assets are going up by the same amount
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$5,500.
Are our liabilities changing? We don't owe
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anyone money. We earned revenue here.
Again owner's equity is increasing
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because our revenues are increasing.
Again revenues affect net income, net
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income affects retained earnings, and
retained earnings is an owner's equity
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account. Let's look at the second
principle: incurring of expenses. Expenses
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as we know create revenues. You've heard
the old saying you have to spend money
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to make money. Well what the matching
principle tells us is that expenses are
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recorded when they are incurred not
necessarily when cash is paid. So again I
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put necessarily here in italics because
we could incur an expense and pay it
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immediately. So expenses are recorded
when incurred not necessarily when cash
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is received. So let's look at another
example. We incurred rent expense of
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$16, 500. And again we'll look at two scenarios.
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We paid cash immediately when the when
the rent was incurred or we got the bill
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and we're going to pay it later. So the
first one else is cash, we paid it
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immediately. How does that affect the
accounting equation? Well does it affect
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assets? If we pay something
it affects cash. Cash is an asset. So
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assets are going down by the $16,500. Our
liability is affected. We're not
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incurring the liability here. We don't
owe someone money in this case because
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we're paying this bill immediately. So it
doesn't affect liabilities. Well what
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about owner's equity? We're incurring an
expense.
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Recall that expenses decrease net income,
so they affect net income, and net income
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affects retained earnings, and retained
earnings is found under the owner's
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equity section of our accounting
equation. So owner's equity is decreasing
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by that $16,500. Now let's look at the
scenario under incurring it on an
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account. So let's see how that will
affect our accounting equation. So again
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our assets being affected in this case.
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Let's look at this scenario as if it's
happening right now.
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Assets are not being affected, however, we
owe this money. We're going to owe this
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money in the future. So for right now
liabilities are increasing. We owe that
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money. What else is happening?
Well owner's equity is still going down
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because we're incurring an expense, and
expenses decreased net income, net income
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affects retained earnings and retained
earnings, as part of owner's equity. So
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it's making owner's equity go down and
even though nothing happened on the
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left-hand side of the accounting
equation we still balance. There was no
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change to the accounting equation at all
because the right side went up by
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$16,500 and it
went down by $16,500.
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So there's no change there. Well
if this is what
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today right now, what will happen in the
future when we pay this bill or pay off
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this rent expense? So let's look at what
will happen in the future? Will assets be
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affected? When we pay out money, cash is
affected. Cash that's an asset so
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assets will go down by that $16,500. Is
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liabilities affected? Yes, we no longer
owe that debt because we're paying it off.
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So our liabilities are also going down
by $16,500,
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and owner's equity is not being affected
here because we're just paying off a
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debt. And as you can see our accounting
equation still balances.
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