Accrual Accounting and Adjusting the Books

Revenue Recognition and the Matching Principle

Revenue recognition and the matching principle are foundational concepts in accrual accounting. These principles ensure that revenues and related expenses are recorded in the period in which they are earned or incurred, regardless of when cash is received or paid.

• Revenue Recognition Principle: Revenue is recognized when it is earned and realizable, not necessarily when cash is received.

• Matching Principle: Expenses are matched to the revenues they help generate, ensuring accurate profit measurement for each period.

Example: If a company provides services in June but receives payment in July, the revenue is recognized in June.

Adjusted Trial Balance

The adjusted trial balance is prepared after all adjusting entries are made at the end of an accounting period. It ensures that all accounts reflect the correct balances before financial statements are prepared.

• Purpose: To verify the equality of total debits and credits after adjustments.

• Key Adjustments: Accrued revenues, accrued expenses, deferred revenues, deferred expenses, and depreciation.

Example: Adjusting for accrued salary expense ensures that the expense is recorded in the period employees earned it, not when paid.

Preparation of Financial Statements

Financial statements are constructed from the adjusted trial balance. The main statements include:

• Income Statement: Reports revenues and expenses to show net income for the period.

• Statement of Changes in Equity: Shows changes in owners' equity, including net income and dividends.

• Balance Sheet: Presents the company's financial position at a specific date, listing assets, liabilities, and equity.

Example: The income statement for RedLotus Travel, Inc. shows service revenue, various expenses, and net income for June.

Closing the Books

Closing entries are made at the end of the accounting period to transfer balances from temporary accounts to permanent accounts, preparing the accounts for the next period.

• Temporary Accounts: Income, expenses, and dividends (closed to Retained Earnings).

• Permanent Accounts: Assets, liabilities, and shareholders' equity (not closed).

1. Debit each income account for its credit balance; credit Retained Earnings for total revenues.

2. Credit each expense account for its debit balance; debit Retained Earnings for total expenses.

3. Credit the Dividends account for its debit balance; debit Retained Earnings for the same amount.

Example: After closing, the Retained Earnings account reflects the cumulative profit retained in the business.

Percentage-of-Completion Method (Production Method)

Overview and Application

The percentage-of-completion method is used for long-term contracts, such as construction projects, where work extends over multiple accounting periods. This method recognizes revenue and expenses in proportion to the work completed during the period.

• Typical Uses: Highway construction, civil engineering, shipbuilding, and complex system installations.

• Relevant Standards: IAS 11, IAS 18, and local financial reporting acts.

Example: A construction company building a bridge over two years recognizes revenue each year based on the percentage of the project completed.

Revenue Recognition Criteria for Long-Term Contracts

• Delivery and Invoicing Criterion (Sales Method): Revenue is recognized when significant risks and rewards are transferred to the buyer (usually at delivery).

• Percentage-of-Completion Method: Revenue is recognized according to the stage of completion, matching costs and revenues to the period in which work is performed.

Definition of Construction Contracts (IAS 11 & 18)

• An individually negotiated contract for the long-term construction of an asset or a combination of assets forming a project.

• Examples: System installations, interconnected plants, complex equipment.

Key Features of Construction Contracts

• Performance extends over more than one financial year.

• Contracts are made before work starts.

• Ownership often passes to the buyer as work progresses.

• Primary Issue: Allocating revenue and costs to the correct accounting periods.

Matching Principle in the Percentage-of-Completion Method

• Contract costs are recognized as expenses in the periods when the related work is performed.

• Contract revenue is matched with the costs incurred to reach each stage of completion.

Accrual Principle and Profit Computation

• Profit is computed by recognizing revenue and expenses as they are incurred, not when cash is received or paid.

Valuation Procedure

1. Before completion, revenues are shown in the balance sheet as the sales value of the performed part of the contract ("ongoing work in progress").

2. Losses are recognized in full immediately if expected (provision for loss).

3. Progress billings (payments received) are offset against the asset "ongoing work in progress".

Calculation of Percentage of Completion (POC)

If not given, the percentage of completion is calculated as:

Note: Cash payments do not affect revenue recognition under this method.

Examples of Accounting for Construction Contracts

Consider a contract with a total value of 10 million, total costs incurred to date of 3 million, and total budgeted costs of 7.5 million.

Additional Scenarios

• Unexpected Costs (Budget Revised): If costs increase, recalculate POC using the new budgeted total costs.

• Mistakes in Production (Budget Not Affected): Defective production costs are included in incurred costs, but the budget remains unchanged.

• Accounting for a Loss: If total expected costs exceed contract value, recognize the loss immediately.

Accounting When Stage of Completion Cannot Be Determined

If the stage of completion cannot be reliably measured (e.g., software development contracts), use the sales method:

• Revenue: Recognized only at delivery date.

• Expenses: Offset with "work in progress" until delivery; at delivery, WIP is credited and charged to production costs in the income statement.

Summary Table: Key Differences in Revenue Recognition Methods

Additional info: The notes also reference IFRS and Danish Financial Statements Act, which are important for understanding international differences in revenue recognition.