Using the Accrual Method to Record Revenue During an Audit
When you perform an audit, you check a company’s revenue recognition, which has to reconcile with generally accepted accounting principles (GAAP). This means, in most cases, that the straight-out accrual method is applied: A company records revenue when it’s earned and realizable.
The type of business dictates how to apply revenue recognition.
To understand how the accrual method of accounting works, you must understand how your audit client generates revenue-related items. This process starts with an agreement to provide a good or service for payment. However, you also must understand how revenue transactions are handled when your audit client gives a good customer a discount or allows a customer to return its purchase.
Identifying goods or services provided for a fee
The precipitating event in the whole revenue equation is an implicit or written contract between a company and its customer. The contract states that the company will provide an agreed-upon good or service for a set amount of money. For revenue to be earned, the company has to fulfill its part of the contract; for revenue to be realizable, the customer has to be likely to pay.
Here’s an example of an implicit contract: You walk into Target and buy a telephone. It’s implicitly understood that when you take that telephone up to the checkout, you will exchange cash or a claim for cash (a credit card transaction) for the amount on the telephone’s price sticker. An example of a written agreement is a lease. If a business owns a large office complex and rents offices to other businesses, the lease states both the tenant’s and the landlord’s expenses and obligations.
Factoring in customer returns and discounts for early payment
Another part of revenue is sales returns and discounts. It has two components:
Sales returns and allowances: Sales returns reflect all products that customers return to the company after sales are done. Sales allowances reflect a discount in price given to a customer who purchases damaged merchandise.
Sales discounts: Sales discounts reflect any discount a business gives to a good vendor that pays early. For example, a customer’s invoice is due within 30 days. If the customer pays early, it gets a 2-percent discount. So if the invoice is for $100, the customer has to pay only $98. This doesn’t seem like such a big deal, but consider the difference between the invoice amount and payment amount if the invoice is for $10,000 or $100,000.
Sales returns and allowances offset a revenue account, and revenue accounts normally carry credit balances. The sales returns and allowances account carries a debit balance because the account is used to offset revenue. To do that, it has to carry a contrary balance. You can’t assign a positive or negative attribute to debits and credits. Though a credit will decrease an asset, it increases a liability.
Defining earned and realizable revenue
Under the accrual method of accounting, a company records revenue when it’s earned and realizable. Here are the criteria for earned and realizable revenue:
Earned: For revenue to be earned, the job, whether it involves goods or services, has to be complete based on the terms of the contract between the company and the customer.
Realizable: For revenue to be realizable, there’s an expectation that the company will be paid. Under the accrual method, cash changing hands isn’t a requirement of recognition. Any company using the accrual method has an accounts receivable account.
When would revenue not be realizable? If, for instance, after a job is complete (but before the company is paid), a customer closes its doors and disappears or goes into bankruptcy. Here’s an example of how accrual revenue recognition works. Joe’s Auto Repair finishes servicing a car on August 15. The customer picks up the car on August 16 and mails payment to Joe on September 6. The revenue is earned and realizable on August 15 when the job is complete.
To complicate matters, let’s say the customer picks up the car on August 16 and dies the next day, leaving no estate. Is the revenue earned and realizable? Earned, yes. Realizable, no. Joe doesn’t record this transaction as revenue.