Revenue is the price of goods sold and services rendered in a given time period. For example, if the bookstore sells a book for $95, the $95 would be the bookstore’s revenue. If a lawyer provides her service for an hour, and her rate for one hour of service is $400, then the $400 would be the lawyer's revenue.
Expenses are the cost of goods and services used up in a given time period. In the previous example, if the cost of the book to the bookstore is $30, then $30 would be the expense when the book is sold. The lawyer, in the above example, might use up secretarial service, utilities, rent, and so on in the process of providing her service to her clients. These are the ordinary costs of doing business; the cost of all the services that the lawyer uses up would be her expenses.
The matching concept stipulates that the revenues generated for a given time period match the expenses incurred in the process of generating those revenues. When to recognize (realize) revenue depends on which basis of accounting you are using. We have already reviewed the two bases of accounting to record revenues and expenses:
As already stated, in this course we will be using the accrual basis of accounting.
Let's take a look at an example of how mismatching can mislead the stakeholders.
One of the hardest concepts to understand is the matching concept. When we talk about the matching concept, what we're really talking about is matching revenues earned and expenses used to earn that revenue in the same time period. Now, if we think about this, it's very important. Because when we look at our income statement, we're subtracting expenses from revenues to give us net income.
There is only one way to change your net income. And that is either to increase or decrease your revenues or increase or decrease your expenses. But we really aren't allowed to play that game.
Let me tell you about my dad. My father owned an art studio, and every year at the end of the year, he would look at his income statement. And he would think, "Hmm, I don't really want to pay taxes on this net income. How can I reduce it?" Well, it was already the end of the year, so he couldn't change his revenues. But perhaps he could change his expenses.
So between Christmas and New Year's, he would go out and buy stuff. He would buy paper and pens and pencils and chalk and pastels and all the things needed to create art for the next year. Now, he was what we would now call a graphic artist, so he designed things like catalogs, advertisements, and brochures. And all of that was done by hand. So he needed a lot of supplies to do that.
Well, in that last week of the year, my father would also go through his office and he would say, "Hmm, I think we could use a new sound system." Now please understand that for my father, a sound system is a new radio. Maybe one that might have speakers, not necessarily detached speakers, but two speakers: one on each side, so that it gives the appearance of being a stereo.
So every year, he would bring home the old radio and put the new radio in his office. Every year, he might bring home the old lamps and put new lamps in his office. By purchasing all of these items at the end of the year, he would then subtract those payments as an expense against his revenue.
Well, the reality is [BUZZER SOUND], can't do that, Dad. That's against the laws of GAAP (generally accepted accounting principles). Because you see, all those things that you buy at the end of the year, you didn't use any of those in order to create the income that you're subtracting them from.
So what you really did, Dad, was you bought assets. And those assets don't reduce your revenue until you use them to create revenue. So the matching principle says, "No, you can't use those expenses, Dad, even though you bought them in the year 2011. You're not going to really use them to generate revenues until 2012. Sorry." The matching principle says no. We have to match revenues and expenses to the same time period.
If we don't, then what we've done is we've lied to our stakeholders, because when we look at our financial statements, we're really not telling them the truth. We're not telling them how much we really spent in order to earn that revenue. So the matching principle says: You must match expenses to the same time frame in which those expenses were used to create the revenues.