Your income is measured as the difference between resource inflows (revenue and gains) and resource outflows (expenses and losses) over a period of time. There are a number of general methods for determining your income. The most basic is the transaction approach, which compares the amounts used in revenue expenses, gains and losses. This method requires a clear definition of when the income elements should be recognized or recorded in the financial statement. In other words, you must know beforehand when your company will gain net assets and when to list them on your statement to provide the most beneficial use of those assets. Other methods include:
Revenue and Gain Recognition
Under the generally accepted accounting principle of accrual, revenue recognition does not necessarily occur when cash is received. Generally, service organizations such as accounting firms, use the cash basis of accounting and only recognize income when they are paid by a client (not when the client was billed). On the other hand, the recognition of a sale for businesses that sell products and carry inventory occurs when the product is sold, not when payment is received.
Expense and Loss Recognition
In order to determine your income, you must establish criteria for revenue recognition and the principles for recognizing expenses and losses must be clearly defined. Some expenses are directly associated with revenues. These expenses can be recognized in the same period as the related revenues. Other expenses are not associated with specific revenues. These expenses are recognized in the time period when they are paid or they are incurred. Still, other expenses are not recognized currently as expenses because they relate to future revenues; therefore, these expenses are reported as assets. Expense recognition, then, can be divided into three sub-categories: direct matching, systematic and rational allocation, and immediate recognition.
In order to perform direct matching, you must relate your expenses to specific revenues. This is referred to as the "matching" process, in which your revenues that are produced by the sale of goods and reported in the same time period are recognized. Similarly, shipping costs and sales commissions are usually directly related to revenues. Your direct expenses include not only those expenses that have been incurred, but also anticipated expenses that are related to revenues of the current period. After the delivery of goods to your customers, there are still costs of collection, bad debt losses from uncollectable receivables, and possible warranty costs (for product deficiencies). These expenses are directly related to your revenues and should be estimated and matched against recognized revenues for the accounting period.
Systematic and Rational Allocation
The second general expense recognition category involves assets that benefit more than one accounting period. The cost of assets, such as buildings, equipment, patents, and prepaid insurance, need to be spread across the periods of expected benefit in some systematic and rational way. Generally, it is difficult to relate these expenses directly to specific revenues or to specific periods; however, these expenses are necessary if your revenue is to be earned. Examples of expenses included in this category are depreciation and amortization.
Many expenses are not related to specific revenues, but are incurred to obtain goods and services that indirectly help to generate revenues. Because these goods and services are used almost immediately, their costs are recognized as expenses in the period of acquisition. Examples of immediate recognition items include most administrative costs, such as office salaries, utilities, and general advertising and selling expenses. You will find immediate recognition appropriate when your future benefits are highly uncertain. For example, your expenditures for research and development may provide significant future benefits, but they are usually so uncertain that the costs can be written off in the period in which they are incurred. Most losses also fit in the immediate recognition category. Because they arise from peripheral or incidental transactions, your losses do not relate directly to revenues. Examples of losses in the immediate recognition category include losses from disposition of used equipment, natural catastrophes (e.g., earthquakes or tornadoes), and losses from disposition of investments.
The methods you adopt for recognizing expenses and losses should appear reasonable to an unbiased observer and should be followed consistently unless the underlying conditions surrounding the assets change. Some expenses are related to the goods your company produces. These expenses may be deferred in inventory values if the goods are unsold at the end of an accounting period. Examples of expenses deferred in inventory values include depreciation on production machinery and plant insurance. Other expenses are related to accounting periods and should be allocated directly as an expense of the immediate time period. Examples of this include depreciation of delivery trucks and amortization of bond discount.