Explain the Revenue Recognition Principle and How It Relates to Current and Future Sales and Purchase Transactions

Accounting Principles and Assumptions Regulating Revenue Recognition

Revenue and expense recognition timing is critical to transparent financial presentation. GAAP governs recognition for publicly traded companies. Even though GAAP is required only for public companies, to display their financial position most accurately, private companies should manage their financial accounting using its rules. Two principles governed by GAAP are the revenue recognition principle and the matching principle. Both the revenue recognition principle and the matching principle give specific direction on revenue and expense reporting.

The revenue recognition principle, which states that companies must recognize revenue in the period in which it is earned, instructs companies to recognize revenue when a four-step process is completed. This may not necessarily be when cash is collected. Revenue can be recognized when all of the following criteria have been met:

• There is credible evidence that an arrangement exists.
• Goods have been delivered or services have been performed.
• The selling price or fee to the buyer is fixed or can be reasonably determined.
• There is reasonable assurance that the amount owed to the seller is collectible.

The accrual accounting method aligns with this principle, and it records transactions related to revenue earnings as they occur, not when cash is collected. The revenue recognition principle may be updated periodically to reflect more current rules for reporting.

For example, a landscaping company signs a $600 contract with a customer to provide landscaping services for the next six months (assume the landscaping workload is distributed evenly throughout the six months). The customer sets up an in-house credit line with the company, to be paid in full at the end of the six months. The landscaping company records revenue earnings each month and provides service as planned. To align with the revenue recognition principle, the landscaping company will record one month of revenue ($100) each month as earned; they provided service for that month, even though the customer has not yet paid cash for the service.

Let’s say that the landscaping company also sells gardening equipment. It sells a package of gardening equipment to a customer who pays on credit. The landscaping company will recognize revenue immediately, given that they provided the customer with the gardening equipment (product), even though the customer has not yet paid cash for the product.

Accrual accounting also incorporates the matching principle (otherwise known as the expense recognition principle), which instructs companies to record expenses related to revenue generation in the period in which they are incurred. The principle also requires that any expense not directly related to revenues be reported in an appropriate manner. For example, assume that a company paid $6,000 in annual real estate taxes. The principle has determined that costs cannot effectively be allocated based on an individual month’s sales; instead, it treats the expense as a period cost. In this case, it is going to record 1/12 of the annual expense as a monthly period cost. Overall, the “matching” of expenses to revenues projects a more accurate representation of company financials. When this matching is not possible, then the expenses will be treated as period costs.

For example, when the landscaping company sells the gardening equipment, there are costs associated with that sale, such as the costs of materials purchased or shipping charges. The cost is reported in the same period as revenue associated with the sale. There cannot be a mismatch in reporting expenses and revenues; otherwise, financial statements are presented unfairly to stakeholders. Misreporting has a significant impact on company stakeholders. If the company delayed reporting revenues until a future period, net income would be understated in the current period. If expenses were delayed until a future period, net income would be overstated.

Let’s turn to the basic elements of accounts receivable, as well as the corresponding transaction journal entries.

Short-Term Revenue Recognition Examples

As mentioned, the revenue recognition principle requires that, in some instances, revenue is recognized before receiving a cash payment. In these situations, the customer still owes the company money. This money owed to the company is a type of receivable for the company and a payable for the company’s customer.

A receivable is an outstanding amount owed from a customer. One specific receivable type is called accounts receivable. Accounts receivable is an outstanding customer debt on a credit sale. The company expects to receive payment on accounts receivable within the company’s operating period (less than a year). Accounts receivable is considered an asset, and it typically does not include an interest payment from the customer. Some view this account as extending a line of credit to a customer. The customer would then be sent an invoice with credit payment terms. If the company has provided the product or service at the time of credit extension, revenue would also be recognized.

For example, Billie’s Watercraft Warehouse (BWW) sells various watercraft vehicles. They extend a credit line to customers purchasing vehicles in bulk. A customer bought 10 Jet Skis on credit at a sales price of $100,000. The cost of the sale to BWW is $70,000. The following journal entries occur.

Accounts Receivable increases (debit) and Sales Revenue increases (credit) for $100,000. Accounts Receivable recognizes the amount owed from the customer, but not yet paid. Revenue recognition occurs because BWW provided the Jet Skis and completed the earnings process. Cost of Goods Sold increases (debit) and Merchandise Inventory decreases (credit) for $70,000, the expense associated with the sale. By recording both a sale and its related cost entry, the matching principle requirement is met.

When the customer pays the amount owed, the following journal entry occurs.

Cash increases (debit) and Accounts Receivable decreases (credit) for the full amount owed. If the customer made only a partial payment, the entry would reflect the amount of the payment. For example, if the customer paid only $75,000 of the $100,000 owed, the following entry would occur. The remaining $25,000 owed would remain outstanding, reflected in Accounts Receivable.

Another credit transaction that requires recognition is when a customer pays with a credit card (Visa and MasterCard, for example). This is different from credit extended directly to the customer from the company. In this case, the third-party credit card company accepts the payment responsibility. This reduces the risk of nonpayment, increases opportunities for sales, and expedites payment on accounts receivable. The tradeoff for the company receiving these benefits from the credit card company is that a fee is charged to use this service. The fee can be a flat figure per transaction, or it can be a percentage of the sales price. Using BWW as the example, let’s say one of its customers purchased a canoe for $300, using his or her Visa credit card. The cost to BWW for the canoe is $150. Visa charges BWW a service fee equal to 5% of the sales price. At the time of sale, the following journal entries are recorded.

Accounts Receivable: Visa increases (debit) for the sale amount ($300) less the credit card fee ($15), for a $285 Accounts Receivable balance due from Visa. BWW’s Credit Card Expense increases (debit) for the amount of the credit card fee ($15; 300 × 5%), and Sales Revenue increases (credit) for the original sales amount ($300). BWW recognizes revenue as earned for this transaction because it provided the canoe and completed the earnings process. Cost of Goods Sold increases (debit) and Merchandise Inventory decreases (credit) for $150, the expense associated with the sale. As with the previous example, by recording both a sale and cost entry, the matching principle requirement is met. When Visa pays the amount owed to BWW, the following entry occurs in BWW’s records.

Cash increases (debit) and Accounts Receivable: Visa decreases (credit) for the full amount owed, less the credit card fee. Once BWW receives the cash payment from Visa, it may use those funds in other business activities.

An alternative to the journal entries shown is that the credit card company, in this case Visa, gives the merchant immediate credit in its cash account for the $285 due the merchant, without creating an account receivable. If that policy were in effect for this transaction, the following single journal entry would replace the prior two journal entry transactions. In the immediate cash payment method, an account receivable would not need to be recorded and then collected. The separate journal entry—to record the costs of goods sold and to reduce the canoe inventory that reflects the $150 cost of the sale—would still be the same.

Here’s a final credit transaction to consider. A company allows a sales discount on a purchase if a customer charges a purchase but makes the payment within a stated period of time, such as 10 or 15 days from the point of sale. In such a situation, a customer would see credit terms in the following form: 2/10, n/30. This particular example shows that a customer who pays his or her account within 10 days will receive a 2% discount. Otherwise, the customer will have 30 days from the date of the purchase to pay in full, but will not receive a discount. Both sales discounts and purchase discounts were addressed in detail in Merchandising Transactions.