Before starting the business, you thought that recording financial transactions was easy. You will report the transaction as and when it occurs, wherein you sell a $10 product, collect the payment, and record a revenue of $10. If only things were that simple. But the reality is more complicated than you think.
Just give it a thought. Is it right to recognize revenue because you received the payment? Has the business really earned the revenue? Let’s understand it with an example.
Understanding the Concept of Revenue Recognition
X is a tour and travel company that sells tour packages. It started selling packages in January for a tour scheduled for April. In January, it collected a $40,000 payment from selling the packages. Can X recognize this $40,000 as revenue in January? Not exactly. It hasn’t yet earned it.
X can only recognize the revenue once it completes its contractual obligation, which is to complete the tour. The company will recognize the revenue in April when the tour is complete. It will even recognize the expenses incurred to make this tour happen, such as flight tickets, hotel booking, tour guide remuneration, and meal costs in April. Suppose X collected a total revenue of $80,000 from April tour bookings and incurred $60,000 in expenses to make this tour happen. The expenses will be recognized once the revenue is recognized.
Revenue and expenses are not recognized when the payment takes place. They are recognized when the contractual obligation is met. That is where accrual accounting comes into the picture.
How Accrual Accounting Works in Revenue Recognition?
In accrual accounting, a business recognizes the revenue when it has earned it. Correspondingly, the expense is also recognized. As in the case of X tours and travels, advance revenue is recorded in the balance sheet -current liabilities – as prepaid revenue. The advance payments X made to book flights and hotels appear as prepaid expenses in current assets. These prepaid revenues and expenses are removed from the balance sheet when recognized and recorded in the income statement.
Let us reverse the transaction. If a company recognizes revenue after delivering the goods/services but has not received payment, it will appear as Accounts Receivables in the Asset column. If the company recognizes the expense but has not yet made the payment, it will appear as Accounts Payables in the Liabilities column.
Why Is Revenue and Expense Recognition Important for Business?
Why don’t we report transactions based on payments? Because if you record the transaction based on cash payments, you will see wide fluctuations in revenue and expenses.
Prevents Misrepresentation of Financial Health: The accrual accounting matches expense with revenue to avoid misrepresentation in understanding the company’s finances. Let’s take the above example of X tours. If it reported the $40,000 revenue in January and $0 expenses, it would show a wrong picture of the company’s operations. Similarly, if X reports $60,000 expense in March and $0 revenue, it doesn’t show any connection between revenue and expense. And April, when revenue is actually earned, has no transactions.
Accrual accounting records these transactions in April, helping businesses determine their peak season and plan for it by hiring an extra workforce or arranging for capacity.
Consistency in Earnings: Sometimes, you may receive the payment early or late. Such vague earnings make it difficult for the business to identify patterns and consistency. Accrual accounting brings consistency and helps businesses forecast the footfall and accordingly maintain inventory. For instance, toy stores order excess inventory ahead of Black Friday and Christmas by looking at last year’s revenue.
Monitor Cash Flow: A business will focus on fulfilling the contractual obligation while the accounts department will manage accounts receivables and payables.
Now, the big question is what constitutes a transaction. As cash payment is not the ground for recognizing revenue, how will you determine when the contractual obligation is over? For this, you have to dig into the agreement with the client. This process is complicated and has been a debatable topic in many cases.
It is better to seek professional help to recognize revenue as per the accounting standards.
Contact McCay Duff LLP in Ottawa, Ontario, to Help You with Financial Account Statements
A skilled accountant can help you read and understand the client agreement on the revenue recognition front and accurately report accrued revenue. To learn more about how McCay Duff LLP can provide you with the best accounting and bookkeeping expertise, contact us online, or by telephone at 613-236-2367
