The ever-evolving accounting standards are such to help businesses and their stakeholders access meaningful yet cost efficient financial statements. Whether you pride yourself as being a financial statements’ expert, or consider income statements, statement of retained earnings, balance sheet, and statement of cash flows the area of business you prefer not deal with, understanding their implications on your business is a subject that is always beneficial to brush up on. Specifically, how revenues are accounted for through these financial statements are a topic with a deceivingly simple facade.
Financial statements may be accounted for using various accounting methods. The two general methods are the cash method or the accrual method. The accrual method is accepted by the General Accepted Accounting Standards (GAAP), while the cash method is known to be more popular among smaller businesses due to its simplicity. One of the differences between the two methods is revenue recognition. This distinction between the two methods is an important concept to understand when deciding which method works best with a business model.
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 a company sells a product with payment terms of net 30, the company will recognize revenue even though the company has not received payment.The accrual is the only method acceptable for public companies, and the following discusses why it is accepted under the guidelines published for accounting standards.
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 gives general guidelines that are further detailed in the Accounting Standards Codification. Essentially, a conservative approach to recognizing revenue 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 consists of two overarching objectives: proper recognition and accurate measurement.
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. 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. 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.
FASB ASC 605 Revenue Recognition
FASB Concept Statement 5
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
By: Stephanie Carlozzi