Video Transcript: The Major Accounting Principles part 2

Hello and welcome back. We're going to continue discussing the major  accounting principles. Some accountants argue that waiting so long to recognize any revenue is unreasonable. They believe that because revenue producing  activities have been performed during each year of construction, revenue should be recognized in each year of that construction, even if estimates are needed.  The percentage of completion method recognizes revenue based on the  estimated stage of completion of a long term project. To measure the stage of  completion, firms compare actual cost incurred in a period with the total  estimated cost to be incurred on the project. To illustrate, assume that a  company has contracted was contracted to build a dam for $44 million the  estimated construction cost to build a dam is 40 million, and you can calculate  the estimated gross margin by simply subtracting the cost from the seller the  sales price, which will give you the 4 million. The firm recognizes the 4 million  gross margin in the financial statements by recording the assigned revenue for  the year and then deducting actual cost incurred for that year. The formula to  recognize revenue is simply the actual cost incurs, I'm sorry, the actual  construction cost incurred during the period divided by the total estimated  construction cost for the entire project, and you're going to multiply that times  the sales price, and that will give you the revenue recognized for that particular  period. Suppose that by the end of the first year the company had incurred  actual construction cost of $3 million these costs are 75% of the total estimated  construction cost under the percentage of completion method the firm would use the 75% figure to assign revenue to the first year in 2011 if it incurs another 6  million of construction costs in 2012 it incurs the final 4 million of construction  costs. The amount of revenue to assign to each year is as follows. So you're  going to, you're going to use your ratio of actual construction costs to the total  estimated construction costs, and that will give you a percentage. And you're  going to multiply that by the agreed upon price of the dam, and that's going to  give you the amount of revenue to recognize in that particular year. The amount  of gross margin to recognize in each year is as follows, so in 2010 they  recognize $3 million in 2011 they recognize 0.6, 2012 they recognize 0.4 million. For a total of $4 million this company would deduct other costs incurred in the  accounting period, such as General and administration administrative expenses  from the gross margin to determine the net income. For instance, assuming  general and administrative expenses were $100,000 in 2010, net income would  be 2000 or $2,900,000 so expense recognition is closely related to and  sometimes discussed as part of the revenue recognition principle. The matching  principle states that expenses should be recognized as they are incurred to  produce revenues, and expense is the outflow or using up of assets in the  generation of revenue. Firms volunteer, voluntarily incur expenses to produce  revenue. For instance, a television set delivered by a dealer to a customer in  exchange for cash is an asset consumption to produce revenue, its cost 

becomes an expense. Similarly, the cost of services such as labor are voluntarily incurred to produce revenue. The measurement of expenses accountants  measure most assets used in operating a business by their historical cost.  Therefore, they measure a depreciation expense resulting from the consumption of those assets. By the historical cost of those assets, they measure other  expenses, such as wages that are paid for currently at their current costs. So.  The timing of expense recognition implies that a relationship exists between  expenses and revenues for certain expenses such as cost of acquiring or  producing the product sold. You can easily see the relationship. However, when  a direct relationship cannot be seen, we charge the cost of assets with limited  lives to expense in the period benefited as systematic and rational allocation  spaces, depreciation of plant assets is an example. Product costs are costs  incurred in the acquisition or manufacture of goods, as you will see in the next  chapter, included as product cost for purchase goods are invoice freight and  insurance in transit costs for manufacturing companies. Product costs include all costs of materials, labor and factory operations necessary to produce the goods. Product costs attached to the goods purchased or purchased and remain in  inventory accounts as long as the goods are on hand. We charge product cost  to expense when the goods are sold. The result is a precise matching of cost of  goods sold expense to its relative revenue. Period costs are costs not traceable  to specific products and expense in the period incurred selling and  administrative costs are period costs. The gain and loss recognition principle  states that we recognize, we record gains only when realized, but losses when  they first become evident. Thus we recognize losses at an earlier point than  gains. This principle is related to the conserve conservatism concept. Gains  typical typically result from the sale of a long term asset for more than their book value, firms should not recognize gains until they are realized through the sale  or exchange. Recognizing the potential gains before they are actually realized is not allowed. Losses consume assets, as do expenses, however, unlike  expenses, they do not produce revenue. Losses are usually involuntary, such as the loss suffered from destruction by fire on an uninsured building, a loss on the  sale of a building may be voluntary. When a management decides to sell the  building, even though it incurs it's incurring a loss, the full disclosure principle  states that information important enough to influence the decisions of an  informed user of the financial statement should be disclosed, depending on its  nature. Companies should disclose this information either in the financial  statements, in notes to the financial statements or in supplemental statements,  in judging whether or not to disclose information, it is better to err on the side of  too much disclosure rather than too little. Many lawsuits against CPAs and their  clients have resulted from inadequate or misleading disclosure of the underlying  facts.