Exercise-1: Application of realization and matching principles

Learning objective:
This exercise illustrates the practical application of realization and matching principles of accounting.

Exercise-1 (a) – realization and matching principles:

On January 28, Jackson Electronics Company paid XYZ Media $800 cash for eight one-minute advertisements. One of the ads were transmitted in January, five in February, and two in March.

Required:

1. According to realization principle, how much advertising revenue XYZ Media earned from Jackson Company in each of three months?
2. According to matching principle, how much advertising expense Jackson incurred in each of three months?

Solution

Recognition of revenue by XYZ Media:

According to the realization principle (also known as the revenue recognition principle), revenue must be recognized when it is earned. Therefore, XYZ Media must recognize revenue from Jackson Company in the month that the ads have been transmitted. The revenue will be recognized in January, February, and March as follows:

• January: ($800/8 ads) x 1 ad = $100
• February: ($800/8 ads) x 5 ads = $500
• March: ($800/8 ads) x 2 ads = $200

Recognition of expense by Jackson Electronics Company:

According to the matching principle, expenses must be matched to the period in which they contribute to generate revenue. Thus, Jackson must recognize its advertising expense in the period that the ads have been transmitted by the media company. The expense will be recognized in January, February, and March as follows:

• January: ($800/8 ads) x 1 ad = $100
• February: ($800/8 ads) x 5 ads = $500
• March: ($800/8 ads) x 2 ads = $200

Exercise-1 (b) – when is revenue realized?

Harris and Company, a firm of design architects, carried out the following transactions during the month of April 2024:

1. Borrowed $18,500 from City Bank to be repaid in 5 months.
2. Received $35,000 cash by issuing additional shares of common stock.
3. Collected $4,500 cash from an accounts receivable that was originated in March from services rendered to a client.
4. Completed a farmhouse plan for a client in Los Angeles. The $6,200 fee for the project was billed to the client on April 25 and will be collected on May 15.
5. Earned $95 interest on company’s bank account during April. No withdrawals were made during the month.

Required: State whether or not each of the above transactions represented revenue to Harris and Company during April 2024. Give appropriate reasons to support your answer.

Solution:

1. The borrowing of money from a bank or any other source does not represent revenue and does not increase equity. It instead creates a short- or long-term liability depending on the repayment period of the loan.
2. The receipt of cash from the sale of common stock does not constitute revenue. It represents the investment made by shareholders, not the earnings generated by the business. Although it increases equity, it does not result from the sale of goods or the rendering of services to outsiders.
3. The collection of cash from an account receivable does not represent revenue and does not impact equity.
4. The farmhouse plan fee was earned in April and represents the revenue for that month, despite the fact that it will be collected in May.
5. The interest on the bank account was earned in April and represents the revenue of that month, despite the fact that no money was withdrawn from the bank during April.

Exercise-1 (c) – when are expenses incurred?

During July, the activities of Sunshine Landscape included the following transactions and events:

1. Paid $450 to an attorney for legal services rendered in May.
2. Purchased a photocopier machine for $2,500.
3. Paid $52 for petrol purchased for delivery van during July.
4. Paid $1,800 salary to an employee for the work done during July.
5. Declared and paid a dividend of $2,200 to shareholders during July.

Required: Which of the above five items represented expenses for the business in July?

Solution:

1. The payment to the attorney for services rendered in a prior period did not affect equity and was not an expense in July. It instead reduced an existing liability.
2. The cost of a fixed asset cannot be regarded as an expense for the current period. Such transactions do not decrease equity because one asset is exchanged for another. The photocopier was purchased to obtain benefits over a number of periods rather than to generate revenue in the current period. Therefore, this transaction itself does not constitute an expense in July. However, Sunshine will recognize depreciation expense on the machine throughout its useful life.
3. Petrol purchased is an expense because it is generally used up in the current period. These purchases decrease equity and are made for the purpose of generating revenue during the current period.
4. Salary paid to employee for the time worked in July is a July expense. These payments are made to generate revenue and decrease equity.
5. The dividend paid to shareholders does not constitute an expense because it is not paid for the purpose of generating revenue. It instead constitutes a return to the shareholders of a portion of their equity in the entity.

Exercise-1 (d) – realization principle:

Sky Airline provides you with the following information regarding cash received for the sale of tickets during January and February:

1. Cash received in January for February flights: $250,000
2. Cash received in February for February flights: $150,000
3. Cash received in February for March flights: $200,000

Required: Apply the realization principle to determine how much revenue Sky Airlines should report in its February income statement.

Solution:

The realization principle states that revenue should be recognized when it is earned, not necessarily when cash is collected. Thus, Sky will recognize a revenue of $400,000 in its February income statement ($250,000 was collected in January and $150,000 was collected in February).

The $200,000 cash collected in February for March flights is unearned revenue – a liability. It will remain a liability until converted to earned revenue by providing the service to passengers in March.

Exercise-1 (e) – matching principle:

Broad Ideas Consulting has provided the following information regarding the cash paid to its employees during November and December:

1. Salary paid to employees in November for the time worked in October: $4,000
2. Salary paid to employees in November for the time worked in November: $$9,000
3. Salary paid to employees in December for the time worked in November: $5,000

Required: Apply the matching principle to determine how much salary expense Broad Ideas Consulting should report in its November income statement.

Solution:

The matching principle states that expenses should be recognized when they are incurred, not necessarily when cash is paid. Thus, Broad Ideas Consulting will report a salary expense of $14,000 in its November income statement ($9,000 was paid in November and $5,000 was paid in December).

The $4,000 paid in November for work performed in October is the October expense and should have already been recognized as incurred in October.