Revenue Recognition and Matching -- Overview of Important Financial Accounting Principles, Assumptions, Constraints; FAQ

The revenue recognition principle

At any rate, profits and losses are not measured on a cash basis, because a company's long term operating cash flows are more accurately predicted by "net income" measured on an accrual basis. Over short periods of time, operating cash flow is not a good predictor of future operating cash flows, because operating cash flow might not reflect certain future expected cash inflows and outflows and because operating cash flow might not model the relative recurrence of cash inflows and outflows that take place during the period; that is, cash inflows/outflows might correspond to the activities of multiple reporting periods.

SFAC No. 6 says: "Thus, accrual accounting is based not only on cash transactions but also on... other transactions, events, and circumstances that have cash consequences for an entity but involve no concurrent cash movement."

Rather, corporations recognize revenue when the earnings process is judged to be complete and there is reasonable certainty as to collection -- regardless of when cash is received, under the revenue recognition principle. When sales are made on credit, revenue is recognized before the receipt of cash through the creation of an accrued receivables account called accounts receivable.


The accrual basis is reflected in the basic accounting principles

In financial accounting, information is prepared on the operations of corporations, for the benefit of "external users" such as investors, and creditors. After Apple Inc. released its quarterly income statement for the quarter ending March 31, 2012 its stock price jumped $50. Stock prices react quickly to earnings announcements, as investors analyze a company's performance. Investors assess reported earnings compared with what they had expected and revise their estimates of what to expect for future performance. The quick reaction in stock prices shows investors either buying shares in large numbers and bidding up the price or selling shares in large numbers and putting downward pressure on the price. Thereby, financial accounting provides investors and potential investors with information to guide their choices. The reality underlying stock prices is a company's operating performance and; there is a special emphasis on cash flows.


The matching principle

The matching principle requires those expenses be recognized that are directly or indirectly associated with the recognition of revenues in a reporting period, irrespective of when cash is disbursed. The matching of costs and revenues is carried out by different approaches. The first approach recognizes expenses that result from the same activities giving rise to the recognition of revenues; these expenses are directly related to the revenue producing activities that result in revenue recognition. For example, the sale of a product includes the recognition of revenue for cash received (or a receivable) and expense for the cost of the product sold. The second approach associates expenses with revenues recognized during a specific time period, indirectly, based on the assets used to obtain benefits that affect only a specific time period. For example, an employee's salary for a month is a cost incurred to provide benefits that last only during the month in which services are performed. The third approach recognizes expenses, such as advertising for instance, in the period incurred because it can't be determined which period(s) the costs should apply to. The fourth approach recognizes expenses resulting from consumption of assets that benefit more than one reporting period, by a systematic and rational allocation to specific time periods in which the assets are expected to be used. For example, if $100,000 is paid for insurance that covers a five year period, the asset (prepaid insurance) benefits several periods and it is systematically and rationally allocated to insurance expense for 20,000 each year.

The historical cost principle

Another important principle of accounting, the historical cost principle states that asset and liability measurements should be based on the amount transacted on in the original exchange transaction. The advantages of using historical costs to measure assets and liabilities are thus: the asset or liability is recorded at its cash price, the cash price that’s recorded is highly verifiable, and the cash price provides relevant cash flow information. The historical cost principle can be illustrated in an example. If equipment is purchased at $10k and later the supply of the material used to manufacture the equipment shrinks, causing the equipment’s fair value to increase (it might be sold for a few thousand more), it will have no bearing on the accounting value, which is $10k. The benefits are thus: The equipment was purchased at $10k and $10k was the original cash value given in exchange, and; it is the value that was transacted on by independent parties, which makes it an objective, provable value. The alternative might be to speculate how much someone would pay for the equipment, which leads to considerable uncertainty and the possibility of a conflict of interest.

The full disclosure principal

The fourth and final full disclosure principal means that any developments of a nature such that could influence the decisions of users should be disclosed. This principle is subject to practical considerations; so, the cost of providing the material should not exceed the benefit of so doing (see below).

All said, publicly traded companies must issue a "Statement of Cash Flows", in addition to the balance sheet, income statement, and statement of changes in equity. This merely affirms that when it all boils down, people are keenly interested in the cash flows of companies as one factor, perhaps the key factor, influencing their investment decisions.

Assets = Liabilities + Equity

Accounting objectives imply four basic assumptions

In addition to the principles, there are underlying assumptions.

First, based on the economic entity assumption, it is assumed that all business operations can be associated with a given economic entity; and the operations of the economic entity are separate and distinguishable from the operations of its owners and other economic entities.

Second, the assumption is that the business will continue forever, known as the going concern assumption.

The periodicity assumption is important to the practice of reporting earnings in a timely manner. It is assumed the business will continue indefinitely, so in order for earnings to be reported for a given time-frame, the idea of periodicity is necessary. In simple terms, it is important to know how the business is doing from time to time, over the course of its presumed indefinite life.

According to the monetary unit assumption, information in financial statements must be reported in one common unit (i.e. United States dollar).

The cost-effectiveness constraint

The whole purpose of financial accounting is to provide interested parties with information that is helpful to their decision making. Should Bank of America lend money to Google? Should the union argue for higher wages to management?

Q: Should I invest money in Apple Inc.?

A: Well, it depends.

Q: On what?

A: Your demands.

Q: I need a, b, c, and d.

A: Does Apple Inc. have a, b, c, and d?

Q: Good question!

.Accounting standards could require all companies to report their results on a monthly basis for every branch location and product category, in simple to understand layouts. Companies could be required to adopt strict treatments for measurement and classification purposes and be directed to apply the same treatments month after month.

Such a scenario would enable investors and creditors to assess the company's risk and reward. They could easily gauge its performance and ultimately, estimate and forecast the company's unique potential to bring in cash and the risk associated with those projections.

Although investors and creditors would benefit greatly from this level of transparency, information suppliers would incur greater costs. The company would expend considerable resources just to collect, process, and report so much information. Those costs would be compounded by the requirement of having to release monthly financial statements. Importantly, reporting results for particular locations and products would entail the loss of valuable information to rivals. Overall, the costs of providing the information would exceed the benefits of so doing, thereby violating the cost-effectiveness constraint. Potential accounting standards are carefully reviewed and investigated and revised according to public feedback, before they become proposed Statements of Financial Accounting Standards (SFASs), in order to ensure that among other things the costs and benefits have been weighed and considered.

SFAS No. 131 says: "One of the precepts of the Board’s mission is to promulgate standards only if the expected benefits of the resulting information exceed the perceived costs."

The materiality constraint

Another constraint which limits the ordinary pursuit of increasing decision usefulness, the materiality constraint allows for choosing an accounting treatment different from Generally Accepted Accounted Principles (GAAP) provided that the amount in question is immaterial or the item is immaterial.

SFAC No. 8 says: "Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity."


The conservatism constraint

Conservatism in accounting is the practice of subjecting potential revenues and gains to greater scrutiny than potential expenses and losses. Its pervasiveness leads some to contend that in some situations it is best to mitigate potential uncertainties and risks as a practical justification. This means, given two equally viable but different accounting treatments, choosing the one that has the least favorable effect on net income or total assets. For example, bad debt expense is estimated to be either 4% of credit sales or 5% of credit sales, based on historical data. Both estimates are equally probable. Record bad debt expense at 5% of credit sales.

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Q5: What is the most frustrating aspect of accounting?

The coverage of topics is expansive.

Q6: What aspect of accounting is interesting/enticing?

The prospect of understanding a lot of esoteric rules is one nice draw. Also it can serve, together with finance, to improve the way you manage your own financial situation and pave the path to entrepreneurship.

Q7: If accounting is so important to understanding the profitability or potential profitability of a corporation, why haven't I heard about it with respect to the analysis of the stocks?

Ideally, accounting is supposed to provide equal transparency for decision making for all users, but management must also apply its judgment in key accounting situations -- which leaves some margin for distortion.

Q8: What about cooking the books?

This problem drove/is driving the demand for qualified auditors and CPA's.

Q9: Are accountants boring people?

Accounting is technical, but you can't say accountants are boring people, based on the nature of their work.. Maybe some accountants do not love accounting and they choose it as a career to help pay for food and groceries.

Q10: Is it true that accounting is "recession-proof?"

That is a reasonable and defensible statement.

Frequently Asked Questions About Accounting

Q1: Is accounting a difficult subject to learn?

To do well at accounting, you must have an interest in the subject and or be able to pay attention to details. Accounting is probably the most basic technical skill, and it can be interesting in its theoretical aspects.

Q2: I heard debits and credits are confusing -- is there any truth to this?

Accounting is not intuitive in the beginning, and making journal entries is no longer required, but it is still tested for, especially at the beginner levels. If you take it as given, it is rather easy to accept that certain accounts are debit accounts (conventionally) while others are credit accounts.

Q3: What level of math is required to practice accounting?

The common misconception! At worst, there's a hint of algebra. The hard part about accounting is learning the rules and implementing them in actual scenarios; it requires more "analytical" thinking than some people can tolerate.

Q4: What is the relationship between finance and accounting?

Finance and accounting do not overlap much, because finance is about cash and risk, whereas accrual accounting is opposed to the obsession with cash and concerned with its own elaborate system of rules. Business is not entirely conducted in cash, so accounting is necessary to build a model system for measuring costs and revenues, for each company. In the end, people care about cash instead of supposed earnings. so finance is important in certain respects.

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