big deal about revenue and cost recognition for your financial accounting course is the matching principle (see Chapter 5). Generally accepted accounting principles (GAAP) dictates you must associate all recognized revenue both earned and realizable with the expenses you incur to product that revenue. Chapter 10 gives you the revenue side of the matching principle. Chapters 12 and 13 walk you through important steps to match inventory and big asset purchases to revenue.
However, as your financial accounting textbook will point out, in some instances, you don’t have to fully utilize the matching principle. For example, many small businesses use the cash method of accounting (see Chapter 6). Under the cash method, revenue is recorded when it is received, and expenses are recorded when they are paid.
The cash method of accounting is especially suited to service businesses, which don’t sell a tangible product. Rather, a service company provides a knowledge-based work product and purchasing inventory for sale (see Chapter 13) and is not a common part of doing business as a service. Examples of this type of business are dentists, accountants, and lawyers.
To add to the excitement, some businesses have specialized generally accepted accounting procedures (GAAP). Classroom discussions about cash based and specialty GAAP is always a lively in my financial accounting courses.
Landing and take-off slots are the areas owned by airlines to enter and exit airports can be one of their largest assets on the balance sheet. They are accounted for as intangible assets (see Chapter 7), which means their cost is initially taken to the balance sheet and then amortized, which means the cost is transferred to the income statement using an allowable amortization method (see Chapter 7).
Reporting for Small Businesses
Many small businesses are either service or merchandising entities.
A merchandising company buys goods from a manufacturer that are in turn sold to the merchandiser’s customers. This can be wholesale or retail.
For example, say that you went out to buy a new pair of jeans. The clothing store selling the jeans is a retail merchandiser selling to you —the end user or final customer. Looking at this from another angle, maybe the clothing store purchased those jeans from a wholesaler and not directly from the manufacturer.
The wholesaler is a merchandiser, too, because they didn’t make the jeans. Going through the flow, this purchase from the manufacturer is marked up by the wholesaler for sale to the retail shop who further marked them up for sale to you. Suffering from jeans fatigue at this point? Imagine how that pair of traveling jeans feels!
Preparing reports
Spotting the difference between the income statement for a service company and a merchandising company is easier if you see both laid out in front of you. Figure 3-1 walks you through a service company income statement. It’s easy-peasy as you just need to report income and general and administrative operating expenses such as payroll, office supplies expense, and insurance expense.
FIGURE 3-1: Service business income statement.
Service business owner Maggie Cheap makes arrangements each year to open a pop-up tax return preparation service from January 31 to April 15. This year, she is operating out of an office-supply store that is not charging her a formal lease payment. She is making a token payment to cover utilities.
The reason behind the lease arrangement is two-fold. Maggie is doing the office-supply tax returns in barter type arrangement; the fair market value of which Maggie includes in her service revenue. Additionally, the office-supply store owner considers the traffic Maggie’s business attracts to his store as a favorable offset to rental income.
Figure 3-2 tackles the more complex merchandising income statement. Wondering if I completely forgot about manufacturing? I did not! A blown-out income statement for a manufacturing company is the centerpiece of Chapter 10.
Isabella Gabry operates a retail clothing store in downtown Winter Park, Florida. Rollins College is just around the corner from her shop with a built-in market of students looking for jeans and tees.
Chapter 10 walks you through most income and expenses shown on this income statement during the manufacturing company discussion. In this chapter, I want to give a quick-and-dirty explanation for a few that may not be intuitive.
Sales discounts and sales returns and allowances: In this example, discounts include markdowns on clothing Izzie wants to move off the racks so that she can put out fresh inventory. The biggest returns and allowances are when a customer changes their mind and returns a purchase.
Cost of goods sold — purchases: This is an important one, which differentiates between service, merchandising, and manufacturing. Izzie matches the cost of jeans and tees purchased from the manufacturer with the jeans and tees sold during the same time (see Chapter 12).
Purchase discounts and purchase returns and allowances: Sometimes, the manufacturer gives Izzie a break on the price of the garments. There are many reasons why this might happen. In this example, Izzie is getting a $250 overstock discount. Purchase returns and allowances generally take place when the retail shop returns garments to the manufacturer that arrived damages, or maybe the wrong items were shipped.
FIGURE 3-2: Merchandising business income statement.
Comparing Figure 3-1 and Figure 3-2, the big difference is that the service business doesn’t have a cost of goods sold, because a service business normally doesn’t sell a tangible product. Makes sense, right?
You are probably a step ahead of me, but a fantastic example of a minor