9.1 Explain the Revenue Recognition Principle and How It Relates to Current and Future Sales and Purchase Transactions

Accounting Principles and Assumptions Regulating Revenue Recognition

The main revenue recognition objective is to recognize revenue after the company’s performance obligation. This performance obligation is the performance of services or the delivery of goods being carried out in return for an amount of consideration (often cash) the company expects to receive from the customer. To know exactly when and how much revenue to recognize, companies follow FASB’s five-step revenue recognition process in which revenue is recognized at the fifth step. This may not necessarily be when cash is collected, as will be illustrated in a later example. Revenue can be recognized when all of the following criteria have been met:

1. Identify the contract with the customers.
2. Identify the separate performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the separate performance obligations.
5. Recognize revenue when each performance obligation is satisfied.

While a detailed look at each of these five requirements is too involved for an introductory course, we can use a simple example to show the five steps. First, it is important to remember that the accrual accounting method aligns with this principle, and it records transactions related to revenue earnings as the performance obligations are met, not when cash is collected. For example, a landscaping company signs a $600 contract with a customer (step 1) to provide landscaping services for the next six months (step 2) for a total fee of $600 (step 3). Assume the landscaping workload is distributed evenly throughout the six months. The customer sets up an in-house credit line with the company, to be paid in full at the end of the six months. The landscaping company records revenue earnings each month (step 4) as they fulfill their performance obligation, which is providing the landscape service as agreed to with the customer. The landscaping company will record one month of revenue ($100) each month as it meets its contractual requirement, or in other words, fulfills its performance obligation, even though the customer has not yet paid cash for the service (step 5).

Let’s say that the landscaping company also sells gardening equipment. It sells a $200 package of gardening equipment to a customer who pays on credit. While this “contract” is not in writing, the company has an unwritten contract to transfer new, unbroken equipment to the customer for the agreed upon price—even if the company is getting the cash in the future. The landscaping company will recognize revenue $200 immediately, given that they provided the customer with the gardening equipment (product) and thus have completed their performance obligation, even though the customer has not yet paid cash for the product. All five steps essentially occurred simultaneously in this example, as would be true with many retail transactions.

Accrual accounting also incorporates the matching principle (otherwise known as the expense recognition principle), which instructs companies to record expenses related to revenue generation in the period in which they are incurred. The principle also requires that any expense not directly related to revenues be reported in an appropriate manner. For example, assume that a company paid $6,000 in annual real estate taxes. The principle has determined that costs cannot effectively be allocated based on an individual month’s sales; instead, it treats the expense as a period cost. In this case, it is going to record 1/12 of the annual expense as a monthly period cost. Overall, the “matching” of expenses to revenues projects a more accurate representation of company financials. When this matching is not possible, then the expenses will be treated as period costs.

For example, when the landscaping company sells the gardening equipment, there are costs associated with that sale, such as the costs of materials purchased or shipping charges. The cost is reported in the same period as revenue associated with the sale. There cannot be a mismatch in reporting expenses and revenues; otherwise, financial statements are presented unfairly to stakeholders. Misreporting has a significant impact on company stakeholders. If the company delayed reporting revenues until a future period, net income would be understated in the current period. If expenses were delayed until a future period, net income would be overstated.

Let’s turn to the basic elements of accounts receivable, as well as the corresponding transaction journal entries.

Short-Term Revenue Recognition Examples

As mentioned, the revenue recognition principle requires that, in some instances, revenue is recognized before receiving a cash payment. In these situations, the customer still owes the company money. This money owed to the company is a type of receivable for the company and a payable for the company’s customer.

A receivable is an outstanding amount owed from a customer. One specific receivable type is called accounts receivable. Accounts receivable is an outstanding customer debt on a credit sale. The company expects to receive payment on accounts receivable within the company’s operating period (less than a year). Accounts receivable is considered an asset, and it typically does not include an interest payment from the customer. Some view this account as extending a line of credit to a customer. The customer would then be sent an invoice with credit payment terms. If the company has provided the product or service at the time of credit extension, revenue would also be recognized.

For example, Billie’s Watercraft Warehouse (BWW) sells various watercraft vehicles. They extend a credit line to customers purchasing vehicles in bulk. A customer bought 10 Jet Skis on credit at a sales price of $100,000. The cost of the sale to BWW is $70,000. The following journal entries occur.

Accounts Receivable increases (debit) and Sales Revenue increases (credit) for $100,000. Accounts Receivable recognizes the amount owed from the customer, but not yet paid. Revenue recognition occurs because BWW provided the Jet Skis and completed the earnings process. Cost of Goods Sold increases (debit) and Merchandise Inventory decreases (credit) for $70,000, the expense associated with the sale. By recording both a sale and its related cost entry, the matching principle requirement is met.

When the customer pays the amount owed, the following journal entry occurs.

Cash increases (debit) and Accounts Receivable decreases (credit) for the full amount owed. If the customer made only a partial payment, the entry would reflect the amount of the payment. For example, if the customer paid only $75,000 of the $100,000 owed, the following entry would occur. The remaining $25,000 owed would remain outstanding, reflected in Accounts Receivable.

Another credit transaction that requires recognition is when a customer pays with a credit card (Visa and MasterCard, for example). This is different from credit extended directly to the customer from the company. In this case, the third-party credit card company accepts the payment responsibility. This reduces the risk of nonpayment, increases opportunities for sales, and expedites payment on accounts receivable. The tradeoff for the company receiving these benefits from the credit card company is that a fee is charged to use this service. The fee can be a flat figure per transaction, or it can be a percentage of the sales price. Using BWW as the example, let’s say one of its customers purchased a canoe for $300, using his or her Visa credit card. The cost to BWW for the canoe is $150. Visa charges BWW a service fee equal to 5% of the sales price. At the time of sale, the following journal entries are recorded.

Accounts Receivable: Visa increases (debit) for the sale amount ($300) less the credit card fee ($15), for a $285 Accounts Receivable balance due from Visa. BWW’s Credit Card Expense increases (debit) for the amount of the credit card fee ($15; 300 × 5%), and Sales Revenue increases (credit) for the original sales amount ($300). BWW recognizes revenue as earned for this transaction because it provided the canoe and completed the earnings process. Cost of Goods Sold increases (debit) and Merchandise Inventory decreases (credit) for $150, the expense associated with the sale. As with the previous example, by recording both a sale and cost entry, the matching principle requirement is met. When Visa pays the amount owed to BWW, the following entry occurs in BWW’s records.

Cash increases (debit) and Accounts Receivable: Visa decreases (credit) for the full amount owed, less the credit card fee. Once BWW receives the cash payment from Visa, it may use those funds in other business activities.

An alternative to the journal entries shown is that the credit card company, in this case Visa, gives the merchant immediate credit in its cash account for the $285 due the merchant, without creating an account receivable. If that policy were in effect for this transaction, the following single journal entry would replace the prior two journal entry transactions. In the immediate cash payment method, an account receivable would not need to be recorded and then collected. The separate journal entry—to record the costs of goods sold and to reduce the canoe inventory that reflects the $150 cost of the sale—would still be the same.

Here’s a final credit transaction to consider. A company allows a sales discount on a purchase if a customer charges a purchase but makes the payment within a stated period of time, such as 10 or 15 days from the point of sale. In such a situation, a customer would see credit terms in the following form: 2/10, n/30. This particular example shows that a customer who pays his or her account within 10 days will receive a 2% discount. Otherwise, the customer will have 30 days from the date of the purchase to pay in full, but will not receive a discount. Both sales discounts and purchase discounts were addressed in detail in Merchandising Transactions.

Your Turn

Maine Lobster Market

Maine Lobster Market (MLM) provides fresh seafood products to customers. It allows customers to pay with cash, an in-house credit account, or a credit card. The credit card company charges Maine Lobster Market a 4% fee, based on credit sales using its card. From the following transactions, prepare journal entries for Maine Lobster Market.

Aug. 5	Pat paid $800 cash for lobster. The cost to MLM was $480.
Aug. 10	Pat purchased 30 pounds of shrimp at a sales price per pound of $25. The cost to MLM was $18.50 per pound and is charged to Pat’s in-store account.
Aug. 19	Pat purchased $1,200 of fish with a credit card. The cost to MLM is $865.

Solution

Your Turn

Jamal’s Music Supply

Jamal’s Music Supply allows customers to pay with cash or a credit card. The credit card company charges Jamal’s Music Supply a 3% fee, based on credit sales using its card. From the following transactions, prepare journal entries for Jamal’s Music Supply.

May 10	Kerry paid $1,790 for music supplies with a credit card. The cost to Jamal’s Music Supply was $1,100.
May 19	Kerry purchased 80 drumstick pairs at a sales price per pair of $14 with a credit card. The cost to Jamal’s Music Supply was $7.30 per pair.
May 28	Kerry purchased $345 of music supplies with cash. The cost to Jamal’s Music Supply was $122.

Solution