Join Jim Stice for an in-depth discussion in this video Story of two brothers on a consulting project, part of Running a Profitable Business: Revenue Recognition.
- Let's say that a company's accounting year ends on December 31st. How long is it between when the year ends and when the company is finished preparing its balance sheet and income statement. - Oh, it takes about two months. - Two months? What are the accountants doing during those two months? - Well, the accountants are making accrual adjustments. - Cruel, did you say cruel? - No, accrual. An income statement reflects a company's economic performance. Net income is a very sophisticated measure. To get that sophisticated measure, the accountants have to make fine-tuning adjustments to the raw data.
These fine-tuning adjustments are called accrual adjustments. - We're going to need an example. - Okay, let's say that we got two brothers, you and me. We sign a contract to do a consulting project for $20,000. - Excellent. - Right. So let's assume that this year, we do half the work, or $10,000 worth. But we only collect 10% of the cash, or $2,000. How much revenue should we report from the project for this year? - Okay, so we did $10,000 worth of work, but only collected $2,000 in cash.
Are they going to pay us the rest of the cash later? - Sure, they'll pay us next year. - Well, economically, we did $10,000 worth of work, so if revenue is a measure of economic performance, it should be $10,000. - You're correct. But the raw data say you only collect $2,000 in cash. With the accrual adjustments, the accountants convert this raw cash flow data into more sophisticated measures of economic performance. - That sounds difficult, but important. - Well, you're right on both counts. Accrual accounting is the heart of modern accounting.
When talking about when to report a sale, the specific accounting phrase that is used is revenue recognition. - So the idea of revenue recognition is that the reporting of revenue, or a sale, is not tied to the timing of the collection of the cash. - That's correct. Sometimes you should report revenue before you collect the cash. Sometimes you should report revenue after you collect the cash. And sometimes you should report revenue at the same time as you collect the cash. - So, what's the underlying concept here? - Companies should report revenue when they deliver economic value, which is not necessarily the same time that they collect the cash.
But without recognizing revenue, a company can't hope to report any profit. Accordingly, company management is typically under great pressure to recognize revenue as soon as possible. Want to understand these concepts better? Join professors Jim and Kay Stice as they introduce the theory, practice, and implications of revenue recognition. Together they demonstrate how this seemingly innocent accounting topic can turn a reported profit into a reported loss, sometimes with multibillion dollar implications for company values.
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- Defining revenue recognition
- Timing revenue recognition
- Understanding multi-element transactions
- Valuing companies
- Reviewing the great revenue frauds and scandals of history