GAAP – Revenue Recognition Principle
This discussion focuses on the objectives, description and application of this principle. Examples will be given to strengthen the understanding and capability to apply this principle at real situation.
Objective:
To set forth the criteria for recognizing and recording revenue in the accounting period.
Description:
According to the revenue recognition principle, revenue must be reported when it is realized and earned, not necessarily when the actual cash is received. In addition, the following four criteria or conditions must also be met for revenue to be recognized:
1. Delivery has occurred or services have been rendered
2. Persuasive evidence of an arrangement for customer payment exists
3. Price is fixed or determinable
4. Collection is reasonably assured
Application:
Revenue is an item that investors and analysts always pay attention to. In order to avoid misrepresentation (overstatement and understatement) of revenue, GAAP has provided additional guidance for revenue reporting for different situations.
For the traditional retail business, goods are delivered to the customers at the same time cash is received, and revenue will be recognized at the time of sales. However in other case that cash could be collected before or after goods or services are delivered, the timing of cash receipts from customers does not dictate when businesses report revenues.
Instead, revenue will usually be recognized when the title, risks, and rewards of ownership have transferred to the customers. Depending on the situations, revenue may be recognized at different point of time.
Example #1 (cash received at the same period goods/services delivered):
The newspaper stand sells Macao Daily News to a customer who pays $4 cash and takes away the newspaper immediately.
Entries:
Dr. Cash…………… $4
Cr. Revenue…………..$4
Since cash is received at the same time the newspaper is delivered and all the four criteria are met, revenue will be recognized right away:
Example #2 (cash received before goods/services delivered):
On Jan 1, the Fortune Magazine has received a subscription form and $120 from an IFT student for subscribing 12 issues of Fortune Magazine ($10/issue). The student will receive 1 issue of the magazine on the last day of each month for 12 consecutive months. Entries:
Jan 1 (cash received):
Dr. Cash………………$120
Cr. Unearned revenue …..... $120
Jan 31 (and last day of every month):
Dr. Unearned revenue… $10
Cr. Revenue ………………..$10
When the company received the $120 annual subscription fee for the magazine, criteria #1 has not been met and revenue could not be recognized at that point of time. The cash received represented obligations to provide future magazine issues to the students which will be booked to the “Unearned Revenue” account temporarily.
By definition, “Unearned Revenue” is the collection of cash from customers or clients before goods or services are delivered. Since the goods or services have not been delivered yet, the revenue cannot be considered as “earned”, these cash receipts are considered future obligations to the customers and will be booked to “Unearned Revenue” as a liability account. Only when the goods or services are partial ly or fully delivered, the n the related amount will be unwound from the “Unearned Revenue” account and finally be recognized as “Revenue” earned.
In the above example, by the end of each month when the company deliveries the magazine to the student, it earns and records the revenue and reduces the liability account or “Unearned Revenue” account balance.
Example #3 (cash received after goods/services delivered):
An old customer filled in the cleaning form and dropped off his jacket for cleaning at Dave’s Dry Cleaning on June 30, listed price for cleaning such jacket is $30. Dave cleans the jacket on July 1, but customers do not claim and pay for the jacket until August 1. Entries:
June 30 (Customer requests service):
No Journal Entry
