Question

The financial accounting standards board (FASB) has new rules for recognition of revenue that went into effect for the financial reporting periods beginning after December 15, 2017. Discuss and explain with examples the revenue recognition rules.

Answer 1

So, let's break down the definition of revenue recognition to learn a little more about it. The definition states that revenue is recorded when it is realized. Realized means that products or services have been exchanged for cash. It also says that revenue can be realizable and still be recognized. Realizable means that products or services have been exchanged, but payment was not received and is expected to be received at a later date. The final component of the definition says that revenue must be earned. Earned simply means that services have been performed or goods have been exchanged.

Beyond that, there are a few more criteria that have to be checked off the list before revenue can be recognized and recorded. For starters, the manner in which revenue is generated must be considered complete or almost complete to count the revenue in the associated accounting period. Second, there must be a reasonable sense of assurance that the revenue earned is actually going to be received.

The third criterion in regards to revenue recognition is in conjunction with another GAAP principle called the matching principle. This concept states that the costs that are associated with generating revenue must be reported in the same time period as the revenue. Let's look at an example.

Bob builds fences. On the last day of June, he has almost finished constructing a nice privacy fence for Joe. The only thing that he has left to do is to install a gate. The gate is scheduled to arrive from the supplier the next day. Bob gives Joe the invoice for the cost of constructing the fence and promises to install the gate as soon as it comes in. Joe won't be paying Bob until the next day, when the job is 100% complete. Since it's the end of the accounting period and payment will not be received until the first day of the new accounting period, does Bob claim the revenue in this period or in the next?

Bob counts the revenue in the current accounting period, even though the payment has not been received yet. Why? Because the situation meets all criteria needed for revenue to be recognized and recorded. He has almost 100% completed the job, he's confident that payment will be received, the revenue is earned and realizable. It also meets the standard set by the matching principle, since the expenses that Bob incurred to erect the fence occurred in this accounting period, even though pay won't be received until the next period.

Some companies recognize revenue after the manufacturing process but before the sale actually takes place. Mining, oil, and agricultural companies use this system because the goods are marketable and effectively sold as soon as they are mined.

The last exception to the revenue recognition principle is companies that recognize revenue when the cash is actually received. This is a form of cash basis accounting and is most commonly found in installment sales.

Bob’s Billiards, Inc. sells a pool table to bar on December 31 for $5,000. The pool table was not paid for until January 15th and it was not delivered to the bar until January 31. According to the revenue recognition principle, Bob’s should not record the sale in December. Even though the sale was realizable in that the sale for $5,000 was initiated, it was not earned until January when the pool table was delivered.

– Johnson and Waldorf, LLC is an accounting firm that provides tax and consulting work. During December, JW provides $2,000 of consulting work to one of its clients. The client does not pay for the consulting time until the following January. According to the revenue recognition principle, JW should record the revenue in December because the revenue was realized and earned in December even though it was not received until January.