Accrual basis and revenue recognition
Accrual accounting records revenue when it is earned and expenses when they are incurred, giving a truer picture of performance than simply tracking cash.
Cash basis versus accrual basis
Under cash-basis accounting, revenue is recorded when cash is received and expenses when cash is paid. Under accrual-basis accounting, revenue is recorded when earned and expenses when incurred, regardless of when cash moves. GAAP and IFRS require accrual accounting for most businesses because it better matches results to periods.
Why accrual matters
Suppose a company completes a 30,000-dollar project in December but is paid in January. Cash accounting shows no December revenue; accrual accounting records December revenue, reflecting the work actually done. Cash basis can make performance look erratic and misleading.
The revenue recognition principle
Revenue is recognised when a company satisfies a performance obligation by transferring goods or services to a customer. The current standard, ASC 606 in the US and IFRS 15 internationally (both effective from 2018 for most companies), sets out five steps for recognising revenue.
The five-step model
The five steps are: identify the contract with the customer; identify the performance obligations (distinct promises); determine the transaction price; allocate the price to the performance obligations; and recognise revenue when (or as) each obligation is satisfied. A phone sold with a two-year service plan, for example, splits revenue between the phone and the service.
Over time versus at a point in time
Some obligations are satisfied at a point in time, such as selling goods in a shop. Others are satisfied over time, such as a 12-month software subscription or long construction projects, where revenue is recognised gradually as the work is performed.
The expense recognition (matching) principle
Expenses are recognised in the same period as the revenues they help generate. Cost of goods sold is expensed when the related sale is recognised; sales commissions are expensed with the sales; equipment costs are spread over the years the equipment is used through depreciation.
The time period assumption
The time period assumption divides a business's life into artificial periods, such as months and years, so performance can be reported regularly. Because transactions often span periods, adjusting entries are needed to assign revenues and expenses to the right periods.
Worked example
A gym sells a 12-month membership for 1,200 dollars, paid upfront on 1 October. Under accrual accounting, it records the cash as unearned revenue (a liability). Each month it recognises 100 dollars of revenue. By 31 December, it has recognised 300 dollars of revenue for the year, with 900 dollars still unearned.
Key takeaways
Cash basis records revenue and expenses when cash moves; accrual basis records them when earned or incurred and is required by GAAP and IFRS for most businesses. Revenue is recognised when performance obligations are satisfied, following ASC 606 and IFRS 15's five steps. Obligations may be satisfied at a point in time or over time. The matching principle records expenses with related revenues. The time period assumption requires period-end adjustments.
Flashcard
Records when cash moves
Check your understanding
A consultant completes work in March but is paid in April. Under accrual accounting, when is the revenue recorded?