Projekt współfinansowany ze środków Unii Europejskiej w ramach Europejskiego Funduszu Społecznego

Fundamentals of Financial Accounting

Rafał Grabowski

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Contents
Introduction ........................................................................................................................................... 4
CHAPTER I Business Environment and Accounting ................................................................................. 5
I.1 Information as a Basis of Wise Decisions about Allocation of Resources ........................... 5
I.2 The General Concept of Accounting.................................................................................... 7
I.2.1 The Definition and Types of Accounting ............................................................................. 7
I.2.2 The Monetary Unit Assumption (Principle) ......................................................................... 9
I.2.3 The Balance Method ........................................................................................................... 9
I.2.4 The Entity Assumption (Principle) ..................................................................................... 12
I.3 Summary............................................................................................................................ 14
I.4 Exercises ............................................................................................................................ 15
CHAPTER II Balance Sheet: the Concept and Recognizing of Assets, Liabilities and Owners’ Equity ... 18
II.1 The General Concept of Financial Statements .................................................................. 18
II.2 The General Concept of a Balance Sheet .......................................................................... 19
II.3 Recognition Criteria of Assets ........................................................................................... 22
II.4 Recognition Criteria of Owners’ Equity and Liabilities ...................................................... 25
II.5 The Actual Layout of a Balance Sheet in Accordance with the Accounting Act ................ 27
II.6 Summary............................................................................................................................ 31
II.7 Exercises ............................................................................................................................ 31
CHAPTER III Business Transactions within the Accounting System (part I)........................................... 37
III.1 Business Transactions and Their Influence on the Financial Position of an Entity ........... 37
III.2 Measurement of business transactions ............................................................................ 41
III.3 Documentation of business transactions .......................................................................... 42
III.4 Recording of business transactions ................................................................................... 44
III.5 Summary............................................................................................................................ 57
III.6 Exercises ............................................................................................................................ 57
CHAPTER IV Profit and Loss Account ..................................................................................................... 68
IV.1 The General Concept of Profit (Loss), Revenues, and Expenses ....................................... 68
IV.2 Recognition and measurement of revenues and expenses .............................................. 71
IV.3 The Division of Income ...................................................................................................... 79
IV.4 Summary............................................................................................................................ 81
IV.5 Exercises ............................................................................................................................ 83
CHAPTER V Business Transactions within the Accounting System (part II) .......................................... 90
V.1 Recording Revenues and Expenses ................................................................................... 90
V.2 Transferring Revenues and Expenses to the “Net Profit (Loss)” Account ......................... 95

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V.3 Summary............................................................................................................................ 98
V.4 Exercises ............................................................................................................................ 98

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Introduction
This manual is designed for students who are starting to learn (study) accounting. It
contains a description of the key issues that are discussed during the course "Accounting".
However, it should be noted that the manual cannot be considered as an alternative to the
lectures - it may be treated only as an addition to the lectures. The manual describes the
theory. However, it also contains examples and exercises that are helpful in understanding
described issues.
This manual was written as a part of the project “Young Teachers Prepare a
Management Course in English” implemented at the Warsaw School of Economics.
Therefore, I offer thanks to all those who initiated and pursued this project.

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CHAPTER IV
Profit and Loss Account

IV.1 The General Concept of Profit (Loss), Revenues, and

Expenses
Owners’ equity is created and affected by actions taken by: (1) owners, and (2) an
entity. Two flagship examples of this statement are: share capital and net profit (loss). Share
capital was explained in the previous part of this book. At this stage we will concentrate on
net profit (loss).
Net profit (loss), in contrast to share capital, is created and affected by an entity.
When an entity is established then it performs on its own account. The performance of an
entity for a reporting period, usually one year (financial year), expressed in terms of money is
called net profit or net loss. Since this issue is more complex it will be explained in detail.
Generally, net profit (loss) is affected by revenues and expenses as follows:

Net profit (loss) = Revenues - Expenses

Increase (decrease) in owners’ equity Increase in owners’ equity Decrease in owners’ equity

Revenues are these increases in owners’ equity which result from business
transactions other than contributions made by owners. In the case of such transactions, on the
one hand the value of owners’ equity increases, on the other hand:
1. the value of assets increases or
2. the value of liabilities decreases.
Referring to the accounting equation, the impact of such business transactions (that
result in revenues) on an entity’s financial position - described in terms of assets, liabilities,
and owners’ equity - may be illustrated as follows.

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1. Assets = Owners’ equity other than net profit (loss)20 + Net profit (loss) + Liabilities
Increase = No effect + Increase + No effect

2. Assets = Owners’ equity other than net profit (loss) + Net profit (loss) + Liabilities
No effect = No effect + Increase + Decrease

Revenues arise as a result of ordinary activities of an entity. In particular, revenues

arise as a result of:
1. the sale of goods (both goods produced by an entity and goods purchased for the purpose
of resale, such as merchandise acquired by a retailer or wholesaler);
2. the rendering of services; and
3. the use by others of an entity’s assets yielding interest, dividend, fees, and royalties.

Example IV.1 Impact of revenues on an entity’s financial position described in terms of

assets, owners’ equity
1. A company X sold goods for PLN 1 000.00. A customer paid in cash.

Assets = Owners’ equity other than net profit (loss) + Net profit (loss) + Liabilities
Cash = No effect + Revenues + No effect
+1 000.00 +1 000.00

2. A company Y provided a service for PLN 1 500.00 on credit.

Assets = Owners’ equity other than net profit (loss) + Net profit (loss) + Liabilities
Receivables = No effect + Revenues + No effect
+1 500.00 +1 500.00

3. A company Z (as a shareholder) received PLN 2 000.00 dividend. Money was transferred
to the entity’s account.

20
It is assumed that “Owners’ equity other than net profit (loss)” includes, in particular share capital, but also
other components of owners’ equity indicated in Chapter II.

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Assets = Owners’ equity other than net profit (loss) + Net profit (loss) + Liabilities
Money in a bank = No effect + Revenues + No effect
+2 000.00 +2 000.00

Revenues include only these inflows of economic benefits which are received and
receivable by an entity on its own account. All amounts that are collected on behalf of a third
party such as value added taxes should not be recognized as revenues.
Expenses are these decreases in owners’ equity which result from business
transactions other than withdrawals of resources that are made by owners. On the one hand
expenses decrease owners’ equity, but on the other hand:
1. decrease the value of assets or
2. increase the value of liabilities.
Expenses that arise in the course of ordinary activities of an entity include, for
example, cost of sales, wages, costs that were incurred in order to produce goods that were
sold. They usually take the form of an outflow of assets such as cash and cash equivalents,
inventory, property, plant and equipment, but also they take the form of the decrease of the
value of assets such as tangible and intangible assets. However, expenses may also take the
form of increases of liabilities, for example resulting from payroll.
Referring to the accounting equation, the impact of both revenues and expenses on
financial position of an entity described in terms of assets, liabilities, and owners’ equity may
be illustrated as follows:

Example IV.2 Impact of revenues and expenses on an entity’s financial position

described in terms of assets, owners’ equity
1. A company X sold goods for PLN 1 000.00. A customer paid in cash. Before the sale,
these goods were classified as inventories. In order to produce these goods the company
incurred expenses (costs) PLN 800.00.

Assets = Owners’ equity other than net profit (loss) + Net profit (loss) + Liabilities
Cash = No effect + Revenues + No effect
+1 000.00 +1 000.00

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Assets = Owners’ equity other than net profit (loss) + Net profit (loss) + Liabilities
Inventories = No effect + Expenses + No effect
- 800.00 -800.00

2. A company Y provided a service for PLN 1 500.00 on credit. In order to provide the
service the company hired employees. Salaries of these employees amounted to PLN
1 300.00. The salaries were: (a) paid by a bank transfer, (b) not paid

Assets = Owners’ equity other than net profit (loss) + Net profit (loss) + Liabilities
Receivables = No effect + Revenues + No effect
+1 500.00 +1 500.00

(a) Assets = Owners’ equity other than net profit + Net profit + Liabilities
(loss) (loss)
Money in = No effect + Expenses + No effect
a bank -1 300.00
- 1 300.00

(b) Assets = Owners’ equity other than net profit (loss) + Net profit (loss) + Liabilities
No effect = No effect + Expenses + Increase
-1 300.00 +1 300.00

IV.2 Recognition and measurement of revenues and expenses

The primary issue in accounting for revenue is determining when to recognise revenue
and in what amount. In order to do that, we have to consider the following rules:
1. the periodicity principle;
2. the accrual principle;
3. the matching principle;
4. specific rules relating to particular groups of revenues and expenses; these rules are
consistent with those listed in points 1 – 3, and are beyond the scope of this book.
External and internal stakeholders need periodic information about assets, owners’
equity, liabilities, and performances expressed as net profit (loss) of an entity. In other words

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useful information should be provided to decision makers promptly and frequently. Therefore
financial statements and other reports are prepared for a specific period the so-called reporting
period such as a month, quarter, six months, or year. The periodicity principle (also called
time period principle) assumes that a company’s activities can be divided into mentioned
periods and business transactions, also business transactions that create revenues and
expenses, should be assigned to those periods.
In reality each business transaction should be assigned to a month in which it took
place. There are at least three reasons for this. Firstly, although we focus on financial
accounting which is distinct from tax accounting – in reality we use one database for financial
accounting, tax accounting, and – to some extent – managerial accounting. Secondly, entities
are obligated to assess the value of income tax monthly. Thirdly, managers need information
in order to evaluate performances for each month.
An entity should keep books of accounts and prepare its financial statements, except a
cash flow statement, using the accrual principle (also called accrual method or accrual
basis accounting). This principle states that items should be recognized as revenues,
expenses, assets, liabilities, and equity when a business transaction take place, not when the
related payment is made or received, even if a payment related to a business transaction
occurs in a different accounting period. The accrual method is included in the Accounting
Act. In accordance with the Act21, “all revenues earned by an entity and all related expenses
which refer to a given financial year, must be recognized in the entity’s books of accounts,
irrespective of the date of their payment”.
The cash principle (also called cash basis accounting) is opposite to the accrual
principle. According to the cash principle revenues should be recognized when cash is
received and expenses should be recorded when cash is paid. It means that net profit (loss)
that is assessed on the basis of the cash principle is the difference between inflows and
outflows of money. In accordance with the Accounting Act entities are obligated to apply the
accrual principle.

21
The Accounting Act of 29 September 1994, article 6.

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Example IV.3 The Accrual Principle versus the Cash Principle

Let us assume that in the course of three months (from October to December 200X) the
company X completed the following business transactions.
Number Date Description
1. 02 October The company provided services on credit (PLN 17 000.00, payment date - 12
November 200X).
2. 05 October The company paid salaries for September 200X (PLN 10 000.00).
3. 07 October The company received money from a customer for the services provided in
September 200X (PLN 20 000.00).
4. 10 October The company provided services for a customer for PLN 27 000.00. A customer
paid in cash.
5. 15 October The company assessed salaries for October (PLN 11 000.00). The salaries should
be paid at the beginning of November 200X.
6. 30 October The company paid a rent for October 200X (PLN 7 000.00).
7. 03 November The company provided services on credit (PLN 35 000.00, payment date - 15
December 200X).
8. 05 November The company paid salaries for October 200X (PLN 11 000.00).
9. 12 November The company received money from a customer for the services provided in
October 200X (PLN 17 000.00).
10. 17 November The company provided services for a customer for PLN 7 000.00. A customer paid
in cash.
11. 23 November The company assessed salaries for November (PLN 12 000.00). The salaries
should be paid at the beginning of December 200X.
12. 27 November The company paid a rent for November 200X (PLN 7 000.00).
13. 05 December The company paid salaries for November 200X (PLN 12 000.00).
14. 15 December The company received money from a customer for the services provided in
October 200X (PLN 35 000.00).
15. 20 December The company assessed and paid salaries for December (PLN 9 000.00).
16. 21 December The company paid a rent for December 200X (PLN 7 000.00).

Required
1. Determine net profit (loss) for each month on the basis of the accrual principle
2. Determine net profit (loss) for each month on the basis of the cash principle.

Answer
On the basis of the accrual principle
October November December
Revenues 44 000.00 42 000.00 0,00
Expenses 18 000.00 19 000.00 16 000.00
Net profit (loss) 26 000.00 23 000.00 -16 000.00

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On the basis of the cash principle

October November December
Inflows 47 000.00 24 000.00 35 000.00
Outflows 17 000.00 18 000.00 28 000.00
Net profit (loss) 30 000.00 6 000.00 7 000.00

Please note that in December the company did not provide any services, however, the
company recognized revenues that amounted to PLN 35 000.00.

The matching principle relates in particular to expenses that we should take into
account in order to measure the value of net profit (loss) for a given reporting period. The
matching principle states that net income (loss) for a given reporting period should be affected
only by:
1. expenses that relate directly to revenues earned during this period and which are included
in net profit (loss); as a result of it revenues and expenses that relate to the same
transaction usually are recognised simultaneously
2. expenses that relate indirectly to revenues earned during the reporting period, but in
amount reflecting the value of resources (also services) used by an entity in order to earn
those revenues
As a result of applying the matching principle arise, among others22, inventories,
prepayments, accruals.

Example IV.4 Applying the Matching Principle

At the beginning of a reporting period the company X had 100 units of finished
products; the unit production cost amounted to PLN 50.00.
During the reporting period the company produced 1,000 units of finished products
and 500 pieces of work in progress. The unit production cost of finished products amounted to
PLN 50.00. The unit production cost of work in progress amounted to PLN 25 (per piece).
Unit price for finished products is PLN 100.00.

22
As a result of applying the matching principle arise also: intangible assets, tangible assets, and provisions.

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Required
1. Determine the value of net (profit) loss and the value of inventories by applying the
matching principle. Assume that the company sold 120 units of finished products.
2. Determine the value of net (profit) loss and the value of inventories by applying the
matching principle. Assume that the company sold all finished products.

Answer
1. The company sold 120 units of finished products
Net profit (loss) = Revenues - Expenses
Revenues = 120 units * PLN 100 (per unit) = PLN 12 000.00
Expenses = 120 units * PLN 50 (per unit) = PLN 6 000.00
Net profit = PLN 12 000.00 – PLN 6 000.00 = PLN 6 000.00

Inventories = Finished products + work in progress

Finished products = (100 units + 1000 units – 120 units) * PLN 50 (per unit) =
= PLN 49 000.00
Work in progress = 500 pieces * PLN 25 (per piece) = PLN 12 500.00
Inventories = PLN 49 000.00 + PLN 12 500.00 = PLN 61 500.00

2. The company sold all finished products

Net profit (loss) = Revenues - Expenses
Revenues = 1 100 units * PLN 100 (per unit) = PLN 110 000.00
Expenses = 1 100 units * PLN 50 (per unit) = PLN 55 000.00
Net profit = 110 000.00 – 55 000.00 = 55 000.00

Inventories = Finished products + work in progress

Finished products = (100 units + 1000 units – 1 100 units) * PLN 50 (per unit) = PLN 0.00
Work in progress = 500 pieces * PLN 25 (per piece) = PLN 12 500.00
Inventories = PLN 0.00 + PLN 12 500.00 = PLN 12 500.00

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Example IV.5 Applying the Matching Principle

Assume that on 1 January 2012 the company Y paid in advance 12 000.00 for an insurance
policy. The policy period lasts from 01 January 2012 to 31 December 2012.

Required
1. Determine the value of expenses resulting from the policy that should be taken into
account in order to assess the value of net profit (loss) for January 2012.
2. Determine the value of expenses resulting from the policy that should be taken into
account in order to assess the value of net profit (loss) for January - March 2012.
3. Determine the value of expenses resulting from the policy that should be taken into
account in order to assess the value of net profit (loss) for 2012.

Answer
1. Expenses resulting from policy = (PLN 12 000.00 / 12 months) * 1 month =
= PLN 1 000.00
2. Expenses resulting from policy = (PLN 12 000.00 / 12 months) * 3 months =
= PLN 3 000.00
3. Expenses resulting from policy = (PLN 12 000.00 / 12 months) * 12 months =
= PLN 12 000.00

In the example IV.5 the value of expenses that should be taken into account in order to
assess the value of net profit (loss) for particular reporting periods (1 month, 3 months, 12
months) is consistent with the matching principle. However, at this stage we should ask about
the rest of payment that is not included in the net profit. How should we recognize 11 000.00
when only 1 000 was recognized as expenses for January? How should we recognize 9 000.00
when only 3 000.00 was recognized as expenses for the period from January to March 2012?
These questions have arisen because – as it was written many times –the accounting equation
always exists. In order to illustrate the issue let us refer to the accounting equation.

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Assets = Owners’ equity + Liabilities

Changes made: Money in a Expenses for -
bank: January:
– 12 000 -1 000.00
Additional changes that should be made in
order to keep the equality +11 000 or -11 000.00 or -11 000.00

As we may conclude - since the accounting always exists - we have to:

1. add PLN 11 000.00 to assets or
2. subtract 11 000.00 from owners’ equity or
3. subtract 11 000.00 from liabilities.
The first answer is correct. We should add 11 000.00 to assets, to the so-called prepayments.
Prepayments (also called prepaid expenses) reflect payments made in advance for
services that will be provided to an entity in the future. Referring to the example IV.5 we may
say that:
1. at the end of January the company has prepayments valued at 11 000.00 and they reflect
the value of future services (that will be rendered form February to December) for which
the company paid in advance;
2. at the end of March the company has prepayments valued at 9 000.00 and they reflect the
value of future services (that will be rendered form April to December) for which the
company paid in advance.
The value of prepayments should be decreased and these decreases should be entered into the
Expense account. Moreover, these decreases should reflect the value of services “consumed”
or “used” by an entity.
Accruals also result from applying the matching principle. Accruals in some sense are
similar to prepayments, however they should be recognized as a part of liabilities. To explain
the concept of accruals let us assume that in December 2011 a supplier X provided to our
company services for PLN 2 000.00 on credit, however, we have not received an invoice. As
it was written, this invoice is necessary because it is a source document that constitutes a basis
for entering the business transaction in our accounts. Does it mean that we should not enter
expenses valued at 2 000.00 in our accounts of December 2011? No, it does not. In fact we

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should assess the value of services provided to our company and instead of the invoice – an
external source document – we should use an internal source document prepared by us. On
the basis of this assessment and the internal source document we should enter: PLN 2 000.00
on the debit side of the Expenses account and 2 000.00 on the credit side of the Accruals
account. Thus, we may say that accruals are also in some sense liabilities, however, in the
case of them entries are made on the basis of internal source documents instead of external
source documents.

Exhibit IV.1 An Example Reflecting an Increase in Accruals

Expenses Accruals
2 000.00 2 000.00

After receiving an invoice we should decrease the value of accruals and increase the
value of liabilities. In the case of our company mentioned above, after receiving the invoice
(for example, let’s assume that we received the invoice in January 2012) we should decrease
the value of accruals by PLN 2 000.00 and increase the value of liabilities (trade payables) by
the same amount. We should make the entry as follows.

Exhibit IV.2 An Example Reflecting a Decrease in Accruals

Liabilities Accruals
2 000.00 (1 1) 2 000.00 2 000.00 OB

In accordance with the Accounting Act, “in order to ensure the matching of the income
and related costs, assets or liabilities and equity of a given reporting period should include
costs or income which relate to the future periods as well as costs relating to this reporting
period, which have not been incurred yet”23.

23
The Accounting Act of 29 September 1994, article 6.

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IV.3 The Division of Income

A profit and loss account (also called an income statement) presents a summary of an
entity’s revenues and expenses for a reporting period, such a month, quarter, or year. A profit
and loss account indicates one of the most important pieces of information about an entity:
1. net profit – when total revenues are greater than total expenses
2. net loss – when total expenses are greater than total revenues.
Business entities are engaged in various activities. As a result, financial effects of
business transactions differ in frequency, predictability, and potential for generating revenues
and expenses. Therefore, revenues and expenses should be divided, disclosed and presented in
groups related to particular types of activities. From external stakeholder’s point of view such
a presentation is very important and useful. It helps them to understand an entity's financial
performance and to make the projections of future results.
In accordance with the Accounting Act revenues and expenses are divided into groups
that are devoted to:
1. operating activities
2. other operating activities
3. financial activities
4. extraordinary events

Exhibit IV.3 The Example of a Simplified Profit and Loss Account

2010 201124
A. Net revenues from sales
B. Operating expenses
C. Gross profit (loss) on sales (A-B)
D. Other operating revenues
E. Other operating expenses
F. Profit (loss) on operating activities (C + D - E)
G. Financial revenues
H. Financial expenses
I. Profit (loss) on business activities (F + G – H)
J. Result on extraordinary events
K. Gross profit (loss) (I +/- J)
L. Income Tax
M Net profit (loss)

24
It is assumed that this profit and loss account is prepared for the financial year 2011.

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Operating revenues comprise revenues from sales of finished goods, goods for
resale, materials, and services net of value added taxes. Operating expenses comprise
expenses that directly relate to operating revenues as well as distribution expenses and general
administrative expenses. Expenses that directly relate to operating revenues include: cost of
sales of finished goods, goods for resale, materials, and services.
Other operating revenues and expenses comprise “revenues and expenses which
indirectly relate to operating activities of an entity, in particular revenues and costs relating to:
1. social activities
2. the disposal of items of property, plant, and equipment, items of property, plant and
equipment under construction, intangible assets as well as the maintenance and disposal of
real property and intangible assets classified as investments
3. writing off of expired, forgiven, and uncollectable receivables and payables
4. recognising provisions or the reversal of provisions, except for the provisions related to
financial transactions
5. write-downs of assets and their adjustments
6. compensations, penalties, and fines
7. a free-of-charge transfer or receipt (including a donation) of assets, including also cash for
purposes other than the acquisition or manufacture of items of property, plant, and
equipment, items of property, plant and equipment under construction or intangible
assets”25
Financial revenues include, in particular, revenues from: dividends, interest, disposal
of investments, and investments revaluation. Financial expenses relate to financial revenues
and comprise: interest expenses, value of investments sold, investment revaluation.
Result on extraordinary events include gains and losses arising from events which
are difficult to predict, outside the entity’s operating activities and not related to its general
operating risk.
The difference between all revenues and expenses is called gross profit (loss). Gross
profit (loss) less income tax is called net profit (loss).
In order to determine the value of net profit (loss) we have to transfer all revenues
and expenses to an account titled “net profit (loss)” and close accounts devoted to revenues

25
The Accounting Act of 29 September 1994, article 3.

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and expenses. The “net profit (loss)” account determines the net profit (loss) by collecting all
expenses on the debit side and all revenues on the credit side. If the total debits exceed total
credits, it means that a company incurred a loss. If the total credits exceed total debits, it
means that a company earned a profit.
As a result of transferring all revenues and expenses to an account titled “net profit
(loss)”, all accounts devoted to revenues and expenses must begin and end each period with
zero balances.

IV.4 Summary
Owners’ equity is created and affected by actions taken by: (1) owners, and (2) an
entity. Two flagship examples of this statement are: share capital and net profit (loss). Share
capital was explained in the previous part of this book. In this chapter we concentrated on net
profit (loss).
Net profit (loss) is affected by revenues and expenses. Revenues are these increases in
owners’ equity which result from business transactions other then contributions made by
owners. In the case of such transactions, on the one hand the value of owners’ equity
increases, on the other hand:
1. the value of assets increases or
2. the value of liabilities decreases.
Revenues arise as a result of ordinary activities of an entity. In particular, revenues
arise as a result of:
1. the sale of goods,
2. the rendering of services, and
3. the use by others of an entity’s assets yielding interest, dividend, fees, and royalties.
Expenses are these decreases in owners’ equity which result from business
transactions other than withdrawals of resources that are made by owners. On the one hand
expenses decrease owners’ equity, but on the other hand:
1. decrease the value of assets or
2. increase the value of liabilities.
Expenses that arise in the course of ordinary activities of an entity include, for
example, cost of sales, wages, costs that were incurred in order to produce goods that were
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sold. They usually take the form of the assets outflow such as cash and cash equivalents,
inventory, property, plant and equipment, but also they take the form of the decrease of the
value of assets such as tangible and intangible assets. However, expenses may also take the
form of increases of liabilities, for example resulting from payroll.
The primary issue in accounting for revenue and expenses is determining when to
recognise revenue and expenses, and in what amount. In order to do that, we have to take into
account the following rules:
1. the periodicity principle,
2. the accrual principle,
3. the matching principle,
4. specific rules relating to particular groups of revenues and expenses (these rules are
consistent with those listed in points 1 – 3, and are beyond the scope of this book).
The periodicity principle (also called time period principle) assumes that a company’s
activities can be divided into mentioned periods and business transactions, also business
transactions that create revenues and expenses, should be assigned to those periods. In reality
each business transaction should be assigned to a month in which it took place.
The accrual principle (also called accrual method or accrual basis accounting). states
that items should be recognized as revenues, expenses, assets, liabilities, and equity when a
business transaction takes place, not when the related payment is made or received, even if a
payment related to a business transaction occurs in a different accounting period.
The matching principle relates in particular to expenses that we should take into
account in order to measure the value of net profit (loss) for a given reporting period. The
matching principle states that net income (loss) for a given reporting period should be affected
only by:
1. expenses that relate directly to revenues earned during this period and which are
included in net profit (loss); as a result revenues and expenses that relate to the same
transaction usually are recognised simultaneously
2. expenses that relate indirectly to revenues earned during the reporting period, but in
amount reflecting the value of resources (also services) used by an entity in order to earn
those revenues.

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As a result of applying the matching principle arise, among others, inventories, prepayments,
accruals.
A profit and loss account (also called an income statement) presents a summary of an
entity’s revenues and expenses for a reporting period, such a month, quarter, or year. A profit
and loss account indicates one of the most important pieces of information about an entity:
1. net profit – when total revenues are greater than total expenses
2. net loss – when total expenses are greater than total revenues.
Business entities are engaged in various activities. As a result of that, financial effects
of business transactions differ in frequency, predictability, and potential for generating
revenues and expenses. Therefore, revenues and expenses should be divided, disclosed and
presented in groups related to particular types of activities. From external stakeholder’s point
of view such a presentation is very important and useful. It helps them to understand an
entity's financial performance and to make the projections of future results.
In accordance with the Accounting Act revenues and expenses are divided into groups
that are devoted to:
1. operating activities,
2. other operating activities,
3. financial activities,
4. extraordinary events.

IV.5 Exercises

Exercise IV.1 Revenues, Expenses, and the Matching Principle. Entering Business
Transactions in Accounts
Assume that as at 1 January 200B the company X had the following opening balances.
No Description Balance
1. Intangible assets - software 4 500.00
2. Tangible assets – buildings 320 000.00
3. Tangible assets – equipment 34 500.00
4. Inventories – merchandise (1 000 units * PLN 230) 230 000.00
5. Inventories – office supplies 6 700.00
6. Trade receivables 87 000.00
7. Cash in hand 29 700.00
8. Money in a bank 94 500.00
9. Shares intended for resale 15 000.00

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No Description Balance
10. Short-term prepayments – include only rent paid in December 200A for the 9 000.00
period from January 200B – March 200B.
11. Share capital 230 000.00
12. Supplementary capital 50 000.00
13. Net profit (loss) for the financial year 200A ...................................
14. Trade payables 67 000.00
15. Short-term liabilities – credits (without interest) 18 900.00
16. Payables resulting from payroll. 7 900.00
17. Accruals – a value of electricity used in December 200A 1 200.00

In January 200B the following business transactions took place.

No Description
1. On 3 January 200B the company completed services for PLN 7 900.00. A customer paid in cash.
2. On 5 January the company acquired merchandise (100 units * PLN 230) on credit.
3. On 8 January the company paid by a bank transfer trade payables PLN 12 000.00.
4. On 10 January 200B the company received an invoice for electricity used in December 200A (PLN
1 200.00)
5. On 11 January 200B the company sold 200 units of merchandise on credit. Unit price amounted to
PLN 400.
6. On 15 January the company paid by a bank transfer insurance policy PLN 3 600.00. The policy period
lasts from January 200B to the end of December 200B.
7. On 16 January 200B the company used office supplies valued at PLN 350.00.
8. On 18 January 200B the company provided services for PLN 12 500.00 on credit
9. On 20 January 200B the company paid by a bank transfer a credit instalment PLN 5 000.00 (interest
included in instalment amounted to PLN 300.00).
10. On January 200B the company sold all shares for PLN 14 500.00. Money was transferred to the
company’s account.
11. On 28 January 200B the accountant acquired a new computer PLN for 2 500.00 on credit.
12. On 29 January 200B the accountant assessed the value of salaries for January 2012. The value amounted
to PLN 12 000.00 and should be paid in February 200B.
13. On 30 January the accountant made an entry relating to the rent paid in advance in December 200A.
14. On 30 January the accountant made an entry relating to the insurance policy paid in advance in 200B
and
15. On 31 January 200B the company assessed the value of electricity used in January 200B: PLN 1 500.00.

Required:
1. Open accounts.
2. Enter all business transactions in the accounts.
3. Close the accounts.
4. Prepare a simplified balance sheet.

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Exercise IV.2 Recording Business Transactions, Preparation of a Balance Sheet, and

Preparation of a Profit and Loss Account – Part II (see exercise III.1)

Required
1. Open accounts as at 1 January 2013.
2. Determine:
a. business transactions that create revenues;
b. business transactions that create expenses; include prepayments and accruals.
3. Describe about 10 business transactions related to point number 2.
4. Record business transactions and close the company’s accounts.
5. Prepare a simplified trial balance and a balance as at 31 December 2013.
6. Prepare a presentation. Describe:
a. your company;
b. resources and sources of assets funding that that were necessary for the purpose of
running your company;
c. business transactions that created revenues and expenses;
d. how the core business of your company affected its balance sheet;
e. main problems that you faced.

Exercise IV.3 Multiple choice questions

1. The company X provided services on credit and earned revenues PLN 2 500.00. As a
result of this business transaction:
a) the value of owners’ equity decreased by PLN 2 500.00 and the value of short-term
receivables decreased by PLN 2 500.00
b) the value of owners’ equity increased by PLN 2 500.00 and the value of short-term
receivables increased by PLN 2 500.00
c) the value of revenues decreased by PLN 2 500.00 and the value of trade receivables
decreased by PLN 2 500.00
d) the value of revenues increased by PLN 2 500.00 and the value of trade receivables
increased by PLN 2 500.00

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2. In December 200A the company sold goods to a customer for PLN 2 000.00 on credit. In
January 200B the customer paid by a bank transfer. It means that in January 200B:
a) the value of revenues increased by PLN 2 000.00 and the value of trade receivables
increased by PLN 2 000.00
b) the value of revenues increased by PLN 2 000.00 and the value of money in a bank
increased by PLN 2 000.00
c) the value of trade receivables decreased by PLN 2 000.00 and the value of money in a
bank increased by PLN 2 000.00
d) the value of trade payables increased by PLN 2 000.00 and the value of money in a
bank increased by PLN 2 000.00
3. At the beginning of January 200A the company paid by a bank transfer insurance policy
PLN 2 400.00. The policy period lasts from January 200A to the end of December 200A.
On this basis we may say that at the end of March:
a) the value of accruals amounted to PLN 1 800.00
b) the value of accruals amounted to PLN 600.00
c) the value of prepayments amounted to PLN 1 800.00
d) the value of prepayments amounted to PLN 600.00
4. At the beginning of January 200A the company assessed the value of electricity used in
January 200A (PLN 250.00) because the company has not received an invoice. The
invoice was delivered to the company at the end of March 200A (PLN 250.00). As a result
of that in March:
a) the value of accruals increased by PLN 250.00
b) the value of accruals decreased by PLN 250.00
c) the value of prepayments increased by PLN 250.00
d) the value of prepayments decreased by PLN 250.00
e) PLN 250.00 should be entered on the debit side of in the “Expenses” account
f) PLN 250.00 should be entered on the debit side of in the “trade payables account”
5. The company X acquired shares of the company Y. In 200A the company X received
dividend PLN 4 000.00 from the company Y. In accounts of the company X this dividend
should be entered as follows:

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a) PLN 4 000.00 on the debit side of the “Revenues” account and PLN 4 000.00 on the
credit side of the “Money in a bank” account
b) PLN 4 000.00 on the credit side of the “Revenues” account and PLN 4 000.00 on the
debit side of the “Money in a bank” account
c) PLN 4 000.00 on the credit side of the “Money in a bank” account and PLN 4 000.00
on the debit side of the “Short-term payables - other” account
d) PLN 4 000.00 on the debit side of the “Money in a bank” account and PLN 4 000.00
on the credit side of the “Short-term payables - other” account
6. In March 200B the General Meeting of Shareholders of the company X approved the
financial statements for the financial year 200A and decide to distribute the profit (PLN
4 000) in the form of dividends. The company X paid dividends at the end of March 200B.
In accounts of the company X this dividend should be entered as follows:
a) PLN 4 000.00 on the debit side of the “Revenues” account and PLN 4 000.00 on the
credit side of the “Money in a bank” account
b) PLN 4 000.00 on the credit side of the “Revenues” account and PLN 4 000.00 on the
debit side of the “Money in a bank” account
c) PLN 4 000.00 on the credit side of the “Money in a bank” account and PLN 4 000.00
on the debit side of the “Short-term payables - other” account
d) PLN 4 000.00 on the debit side of the “Money in a bank” account and PLN 4 000.00
on the credit side of the “Short-term payables - other” account
7. The accrual principle states that:
a) a company’s activities can be divided into mentioned periods and business
transactions, also business transactions that create revenues and expenses, should be
assigned to those periods
b) items should be recognized as revenues, expenses, assets, liabilities, and equity when a
business transaction take place, not when the related payment is made or received,
even if a payment related to a business transaction occurs in a different accounting
period
c) revenues should be recognized when cash is received and expenses should be recorded
when cash is paid. It means that net profit (loss) that is assessed on the basis of the
cash principle is the difference between inflows and outflows of money

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d) net income (loss) for a given reporting period should be affected only by expenses
that relate directly to revenues earned during this period expenses that relate indirectly
to revenues earned during the reporting period, but in amount reflecting the value of
resources (also services) used by an entity in order to earn those revenues.
8. The cash principle states that:
a) a company’s activities can be divided into mentioned periods and business
transactions, also business transactions that create revenues and expenses, should be
assigned to those periods
b) items should be recognized as revenues, expenses, assets, liabilities, and equity when a
business transaction take place, not when the related payment is made or received,
even if a payment related to a business transaction occurs in a different accounting
period
c) revenues should be recognized when cash is received and expenses should be recorded
when cash is paid. It means that net profit (loss) that is assessed on the basis of the
cash principle is the difference between inflows and outflows of money
d) net income (loss) for a given reporting period should be affected only by expenses
that relate directly to revenues earned during this period expenses that relate indirectly
to revenues earned during the reporting period, but in amount reflecting the value of
resources (also services) used by an entity in order to earn those revenues.
9. The matching principle states that:
a) a company’s activities can be divided into mentioned periods and business
transactions, also business transactions that create revenues and expenses, should be
assigned to those periods
b) items should be recognized as revenues, expenses, assets, liabilities, and equity when a
business transaction take place, not when the related payment is made or received,
even if a payment related to a business transaction occurs in a different accounting
period
c) revenues should be recognized when cash is received and expenses should be recorded
when cash is paid. It means that net profit (loss) that is assessed on the basis of the
cash principle is the difference between inflows and outflows of money

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d) net income (loss) for a given reporting period should be affected only by expenses
that relate directly to revenues earned during this period expenses that relate indirectly
to revenues earned during the reporting period, but in amount reflecting the value of
resources (also services) used by an entity in order to earn those revenues.
10. The periodicity principle states that:
a) a company’s activities can be divided into mentioned periods and business
transactions, also business transactions that create revenues and expenses, should be
assigned to those periods
b) items should be recognized as revenues, expenses, assets, liabilities, and equity when a
business transaction take place, not when the related payment is made or received,
even if a payment related to a business transaction occurs in a different accounting
period
c) revenues should be recognized when cash is received and expenses should be recorded
when cash is paid. It means that net profit (loss) that is assessed on the basis of the
cash principle is the difference between inflows and outflows of money
d) net income (loss) for a given reporting period should be affected only by expenses
that relate directly to revenues earned during this period expenses that relate indirectly
to revenues earned during the reporting period, but in amount reflecting the value of
resources (also services) used by an entity in order to earn those revenues.

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