The standard accounting periods are quarterly, combining to form annual statements. Companies also prepare monthly statements. As a rule, the more narrowly defined a reporting period, the more challenging it becomes to capture and measure business activity. Such challenge manifests itself in many ways, and a primary challenge is accounting for revenue earned in prior period. For instance, many businesses provide continuous services to clients and bill clients on a rolling basis, wherein the bill for a month and the resultant revenue reflects service rendered in a previous month or previous accounting period. In such cases, money “earned” during one period finds its way to the account books only during the next period. Such “accruals” and adjustments requires adherence to the relevant rules and procedures of generally accepted accounting principles (GAAP).
Revenue Recognition Principle
The basic principle of recording an item into the accounting records, or revenue recognition is to do so when:
- The transaction takes place, which is when the goods pass to the customer, or when the customer receives the service
- When the company receives payment for such product or service
Look for compliance with both the above conditions. GAAP guidelines do not allow recognizing revenue merely on securing a sales order, or even after completing the manufacturing process on order. Revenue recognition requires actual transfer of the product to the customer. Similarly, receiving advance payment by itself does not constitute revenue. GAAP recognizes revenue only after the conditions of payment, which is usually delivery of the product, is complete.
The USA Securities and Exchange Commission provides additional guidance over GAAP recommendations for revenue recognition. These guidelines recommend recognizing revenue only when there exists persuasive evidence of an arrangement, delivery of the product or service takes place, and the price is fixed or determinable, with collection of payment is either done, or reasonably assured.
The problems related to revenue recognition arises when these two essential GAAP conditions mentioned above take place at different accounting periods. For instance, how to account for payment received in April for a product sold in January? When payment does not accompany point of sale, GAAP recommends recording revenue on account.
Record revenue when “earned,” that is when “billed” and payment received. If actual transaction takes place in an earlier period, create a credit entry for the revenue earned, and a simultaneous debit entry for the same amount as account receivables, in the balance sheet for the period when the actual transaction takes place. Adjust the account receivable as income in the balance sheet for the period when receiving payment. When selling on credit, record the same as account receivables, and adjust the account receivables as income on receipt of payment. Advance payments are unearned revenue, and recorded as liabilities or accounts payable, reflecting the company’s obligation to deliver product in the future. Adjust such accounts payables to income on completion of the transaction.
Adjustments usually occur at the end of each accounting period. Every situation is unique, and requires thoughtful consideration. For instance, adjusting multiple payments, or installments make adjustment complex, as does bundled items, such as a product sold with a service contract that may extend for two years, or even lifetime replacement guarantee! The same principles nevertheless apply.
One important point to consider is the “matching principle,” or associating cause and effect. Recording expenses related to the income generated, such as commissions, cost of inventory, and others in the same period of revenue recognition. Record costs not linked to any production of revenue at time of occurrence.
Generally accepted accounting principles (GAAP) require businesses to use “accrual basis” when accounting for revenue earned in prior period. Such stipulations however differ with the simplistic cash based accounting approach used by many small businesses, which account for revenue on receipt of cash, regardless of when “earned”, and similarly recognize expenses on making payments, regardless of when “incurred”. Assigning revenues and expenses to time periods correctly is pivotal in the determination of income. Failure to do so can distort income statements and earnings greatly and cause “accounting failures.”
Principles of Accounting.com. “Chapter 3: Income Measurement.” https://www.principlesofaccounting.com/chapter%203.htm. Retrieved May 23, 2011.
Image Credit: freedigitalphotos.net/Michelle Meiklejohn