The Smith Company: Income Statement

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Table of Contents

Income Statement
Adjustments made to the account
Importance of the matching concept
Reference

Income Statement

The following is the income statement of Smith Company after adjusting some of the items that were not adjusted by the company’s bookkeeper:

Smith Company

Income Statement. For the year ended 31^st December, 2012.

	$	$
Revenues		406000
LESS: COST OF SALES
Cost of goods sold Less: Overstated closing stock	234000 (45500)	(188500)
Gross profit		217500
LESS: EXPENSES
Depreciation expense Insurance Marketing expenses Property taxes Rent Salaries Utilities	24350 1400 4500 8900 18000 67500 6700	(131350)
Net profit		86150

Adjustments made to the account

There is one major adjustment made to the above income statement for Smith Company, that is the cost of sales figure. When the client of the company showed intention to purchase from the company, the bookkeeper recorded the transaction as a sale and indicated that some of the stock had left the company. In essence, when determining the cost of sales, the bookkeeper’s records showed a lower closing stock figure than the actual stock levels in the company. This understated the profits of the company since it resulted in a higher cost of sales figure. It is this flaw that has necessitated an adjustment to the cost of sales figure by subtracting the unadjusted amount of $45500 so as to reflect the real cost of sales.

This transaction was also expected to affect the debtors figure in the debtors control account. I presume that following the double entry concept, the bookkeeper had credited the sales account and debited the debtors control account. Since the sales account was adjusted after realizing no commitment on the side of the client to make the purchase, it was also necessary to adjust the debtors control account in order to cancel out the transaction completely. It is not clear from the books as to whether the adjustment was made by the bookkeeper on the debtors control account. However, the debtors control account adjustment has no effect on the income statement since debtors do not form part of the income statement items.

Other items of the income statement remain unaltered since there are no other clear flaws in the preparation of the books of accounts by the bookkeeper. However, the adjustment of the above transaction results in different figures for the gross profit and the net profit of the company; which is an increase in the figures by an amount of $45500.

Importance of the matching concept

The matching concept of accounting is also referred to as the revenue recognition principle. It states that the expenses of an accounting period should be matched with the revenue generated during that period. All other costs incurred during the period that do not relate to the activities of the organization to create revenue are excluded from the period expenses calculations. It states that expenses should follow the revenues, that is why only the revenues generated during an accounting period should bear the costs incurred in the course of generating them (Hermanson & Edwards, 2005). Therefore, expenses are not recognized in the books of accounts when cash is received by the company or when services are rendered to the company by other parties. They are only recognized in the books when their commitment leads to the generation of revenue. All the costs incurred during the period that do not relate to that period’s revenue creation are accounted for as current assets in the form of prepaid expenses. Those incomes received by the company that relate to the future revenue creation activities are omitted from the income statement for the period and are treated as current liabilities in the statement of financial position.

The following is the importance of the matching concept of accounting as deduced from the discussion:

By matching the revenues generated during the period with the costs incurred during the same period, you neither overstate nor understate the company’s earnings for the period. Consequently, the accounting exercise leads to the creation of a true report about the real value of the business.
If an organization fails to apply the matching principle in its accounting practices, it is possible to be spending more money than it generates, thus resulting in major losses at the end of the accounting period.
It is important to use the matching concept in accounting for the purposes of making major decisions affecting the company’s operations. If a company fails to employ the matching concept, it could result in false conclusions by users of the financial statements regarding their future engagements with the company. For instance, a profit-generating company may report losses at the end of the period after paying a lump sum amount of money in advance. This may be a bad signal to a potential future investor who may shun away from investing in the company, citing that the company is making losses.

Reference

Hermanson, R. H., & Edwards, J. D. (2005). Financial accounting: a business perspective. Minnesota: Freeload Press.

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The Smith Company: Income Statement

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