Revenue Recognition

In our examples so far, I’ve looked at a simple accounting system. Whenever cash is received, we make revenue and whenever cash is spent, we incur expenses. In this chapter, I will look at two approaches: the simple cash basis and the (more commonly used) accrual basis for determining when we made and spent money.

Cash Basis

In the Cash Basis approach, it is simple to determine when you made revenue. As soon as you get paid! So, if you sell a product on December 19th of this year for $4,000 but don’t get paid until January 5th of next year, you don’t report that $4,000 this year (since you haven’t been paid yet), you report it in the year you are paid (i.e., next year).

Your expenses are not recorded until you pay them. In essence, your checkbook can act as your accounting system.

Simple example

If we take the entries from the first two chapters and move them into a checkbook register, our records might look like the following:

Note that, even though a loan for the computer was made, the cash basis only reflects the payment. In the cash basis, all of the deposits and payments are only recorded when they occur. A checkbook register (and most banking software) serves as the journal of activity.

While this approach is simple to understand, it does not accurately match expenses and revenues. You could easily incur a large amount of expenses in November and December but not get paid until January. So the expenses would be higher this year, with no matching revenue, while next year the revenue will be higher without matching expenses.

Accrual Basis

The Accrual Basis approach, while a bit more involved, does a much better job of associating revenues with the expenses that belong with them. The revenue is recognized as soon as it is earned, not when payment is received. The expenses are recorded when they occur, not when you pay for them.

With the accrual basis, you will need to create additional accounts called Receivables (money owed us) and Payables (money we owe). The recording of revenue for a credit sale is now two journal entries: the first, records the sale and the receivable records it when the sale is made:

Accounts Receivable is considered an asset so we increase it by debiting its balance. Hopefully, within a short period of time, we will close the Accounts Receivable by moving the money into the cash/checking account:

The Accounts Receivable account is essentially a holding bucket for IOUs. In this approach, if you made the sale in December, you would report it as income this year and the following year would simply move the payment from the Accounts Receivable account to checking—without having had any impact on revenue.

Note: One question you might have is, how do you deal with non-payment (i.e., when a customer defaults on his bill)? Such a case is called a bad debt and becomes an expense when the debt is declared bad. This expense will allow you to offset the income that you recorded even if the income came in a prior period. We will cover handling bad debt in a later chapter.

You can also purchase items needed and pay for them on credit by using the Accounts Payable account. For example, you can purchase shipping supplies and put them on your credit card. The journal entry might look like this:

When you pay the credit off, you will reduce cash (by crediting it) and reduce the Accounts Payable (your debt to visa) by debiting it:

Generally, you can have multiple Accounts Payable accounts such as expenses, sales tax collected (yep, when you charge sales tax, you incur a debt to the government), possibly loans payable for that computer purchase, etc.

The Accounts Payable is simply a method to allow you to put the expenses within the same period as when the sale occurs, regardless of when the cash is actually paid out.

Comparing Methods

To compare the two methods, consider the following transactions:

• Customer comes in store on December 21 and purchases a $700 TV.
• Customer pays for it with a VISA card.
• The next day, the store pays $50 to have the TV delivered (included in the price).
• On January 24, payment is received from VISA.

Cash Basis

An income statement prepared on December 31 would not show the $700 revenue, although it would show the $50 delivery expense:

Accrual Basis

An income statement prepared on December 31 would show the $700 revenue and the $50 delivery expense. The net income for this transaction would be $650 (minus the cost of the TV of course).

Taxes

Taxes are collected by various government agencies. For example, they are collected by the Internal Revenue Service (IRS) in the United States and by HM Revenue & Customs (HMRC) in the United Kingdom. In the U.S., the IRS allows small businesses to pay their taxes by using either cash or to do so on an accrual basis. When you first start your business, you are somewhat free to use either approach. (The IRS assumes larger businesses and businesses with inventory, in particular, should use the accrual basis).

However, once you file a tax return, you must use that approach from then on. You can get approval from the IRS to change methods but the IRS will figure out the tax impact of such a change before it allows you to change methods. You can end up with a large tax bill to change methods.

Taxation rules, rates, allowances, etc., will vary for different countries throughout the world. Not all countries will allow cash basis for taxes. An accounting system should provide sufficient detail for the taxing agency to determine the proper revenue recognition and expense handling to accurately determine tax liability.

Multiple Books

You can keep two sets of books, one for tax purposes and the other for financial reporting. It is a common feature in modern accounting systems, which allows you to run reports by using either basis. When reporting to the IRS, companies like to use any legal method to reduce the amount of taxes it owes. However, when reporting to investors, owners, senior management, etc., the accounting system typically wants to show how well the company is performing.

While multiple books are allowed in the U.S., this may not be the case in all countries. The U.S. uses Generally Accepted Accounting Principles (GAAP) to determine accounting rules while most countries (over 100 of them at the time of this writing) use the International Financial Reporting Standards (IFRS) to handle accounting principles.

Summary

The accrual system is common for most mid to large-sized businesses and provides the most accurate matching of revenues and expenses. If you look at the chart of accounts and don’t find Accounts Receivable and Accounts Payable accounts, the business most likely is using the cash basis.