Revenue recognition, is an important aspect of Financial Accounting Reporting. The revenue recognition principle is a core concept to the Generally Accepted Accounting Standards (GAAP), but its simple ideology is a façade, as there are countless situations that complicate this topic. For this reason, a general summary of revenue recognition is presented with the underlying assumption that there are exceptions to these rules dependent on the circumstances.
The generally accepted accounting methods for financial statements are the cash method or the accrual method (Accounting Coach, 2017b). Revenue recognition is the main difference between the two types of accounting for a business financial position, and accounting recognition is when an event is depicted in the financial statements (FASB, 2008, 1). Although there are other differences, the recognition concept distinction between the two methods is an important concept to understand when deciding which method works best with a business model. Items to be recognized on financial statements must meet the definition of an element of financial statements, be relevant, and have reliable measurement (FASB, 2008, 3). These criteria are met in both cash basis and accrual basis accounting, but the difference arises when contemplating if revenues have met the criteria of being earned (FASB, 2008, 3).
Due to the name, it makes sense that the cash method requires recognition of revenue only when the cash is received by the business, and similarly it recognizes expenses when they are paid. Accrual accounting allows for the recognition of revenue when a sale occurs. For example, when amazon fulfils an order, they record that revenue on their books, although the cash may not be received for days or even weeks. The circumstances that revolve around revenue recognition impact the amount and timing of revenue recognition on a company’s books and ultimately an income statement. The principle of accounting standards laid out in concept statement 5, of the FASB Concept Statements, gives general guidelines that are further detailed in the Accounting Standards Codification. Essentially, a conservative approach to recognizing earnings is applied to a variety of situations in a variety of ways in order to give stakeholders the most reliable information feasible within reason. To do so consist of two overarching objectives that are defined in FASB ASC 605 10 25 1: proper recognition and accurate measurement (FASB, 2008, 3).
Recognition must be timely and complete to be acceptable. It is not enough to simply allow a business to accept revenues to function. Rather, they must be properly accounted for in the financial statements and their respective totals, such as net income or owner’s equity. The principle guideline expects a revenue or a gain to be realized or realizable, meaning the amount is accessible, and the exchange must be earned (FASB, 2008, 17). An example might be the service your business offers is completed; therefore, you earned your revenue and may recognize the amount on your books.
This leads to the second objective, which is accurate measurement (FASB, 2008, 18). The complexities arise with situations such as returns of products, service warranties, coupons, and the like. Coupons are a common complication that businesses work into their accounting and impacts revenue recognition by possibly varying the amount recognized or delaying an obligation, such as a future discount. An estimate of the amount of coupons that will be redeemed is the ideal implementation for accrual method accounting, but is just one of many examples of the complications that may arise when it comes to revenue recognition.
Revenues and gains are considered receivables in the near future, and, as such, are valued based on their net realizable value. This meets the expectation of recognizing a realizable, rather than the full amount of the sale price. The FASB ASC 605 further elaborates on the concepts of revenue recognition under accrual accounting.
FASB. (2008). Statement of Financial Accounting Concepts No. 5. Retrieved from https://asc.fasb.org/cs/ContentServer?c=Document_C&sitepfx=FAF&pagename=FAF/Document_C/CodDocumentPage&cid=1218220132773
Stephanie Carlozzi-Master's Degree in Accounting Student at Naveen Jindal School of Management
and is in the 2017 mentoring program at IAA CPA FIRM PLLC
This information is for educational purposes, its not a substitute for consultation with a tax practitioner.If you have any questions contact IAA CPA FIRM PLLC