Revenue Recognition
Principle – Under this principle revenue is to be recorded when it is
realized (or realizable), and when it is earned and not when it is received.
Revenue is realized when goods or services are exchanged, is realizable when
assets received can be converted to cash, and is earned when all necessary
requirements are met entitling the company to the benefits represented by the
revenue (e.g. services performed).
For example, suppose a neighborhood coffee house orders 100
coffee mugs from a coffee wholesaler in June. The coffee house takes delivery
of the new mugs in July and pays for the order in August. The wholesaler does
not recognize the revenue from this sale in June, when the order was placed, or
in August, when the cash was received. For recording purposes, the revenue is recognized by the wholesaler in
July, when the coffee mugs were delivered to the coffeehouse.
This principle is used for the recognition of revenue for
both goods and services. For example, if an attorney is hired with an agreed
upon retainer fee of $2,500 in May, and the services are not performed until
July, the attorney does not recognize the revenue until July. The attorney must earn the income before it
can be recorded as such, even though he/she received cash for the service at an
earlier date.
Historical Cost Principle – The historical cost principle deals with the valuation of both assets and
liabilities. The value at the time of
acquisition is used to value most assets and liabilities. For example, say the coffee wholesaler
purchased an office building in 1990 for $1.2 million. Over time this asset has most likely
appreciated in value. However, in
accordance with the cost principle, the original (historical) price of the
building is what is recorded as the cost of the building in the books of the
business.
Note that another basis for valuing elements of financial
statements is coming into play. The new
basis is fair value. With the
convergence of global standards, fair value is used more in the United States
to value elements of financial statements.
Matching Principle – This principle mandates that the expenses of a business need to line up with
its revenue. The expense or cost of
doing business is recorded in the same period as the revenue that has been
generated as the result of incurring that cost. In the case of the coffee wholesaler, when the 100 coffee mugs were
delivered in July they changed from being a part of inventory (asset) to a cost
of goods sold entry (expense) in the month that the revenue from the sale was
recognized. At this point, the
difference between the revenue and expense is determined as the gross profit
from the sale.
Full Disclosure Principle – This principle states that all past, present and future information that may
have had an impact on the financial performance of the company needs to be fully
disclosed. The historical performance of
a company is readily available, but examining the numbers does not always
provide the entire financial picture of a company. Sometimes there are
alternative situations that need to be reported. Pending or current lawsuits
are one example of a transaction that could severely impact a company’s bottom
line. In addition, incomplete financial transactions
or any other conditions that could impact the company’s performance must also
be disclosed. Most of these transactions are disclosed in the footnotes to the
financial statements.
