Accounting: The Language of Business - Vol. 2 (Intermediate: Part 12)

Maybe it wasn't anything remotely to do with religion, mysticism or metaphilosophy after all; maybe it was more banal; maybe it was just...accounting.

Iain Banks

Financial Reporting Theory (Part F)

by

Charles Lamson

Principles of Recognition and Measurement

What Is Accrual Accounting?

Accrual accounting is a financial accounting method that allows a company to record revenue before receiving payment for goods or services sold and record expenses as they are incurred (investopedia.com).

In other words, the revenue earned and expenses incurred are entered into the company's journal regardless of when money exchanges hands. Accrual accounting is usually compared to cash basis of accounting, which records revenue when the goods and services are actually paid for.

The use of the accrual basis, rather than the cash basis, is the distinguishing feature of financial accounting. We discuss the underlying principles of accrual accounting in the next two posts that include:

• General recognition

• Revenue and expense recognition

• Bases of measurement

General Recognition Principles

Recognition is the process of reporting an economic event in the financial statements. Recognized events are included in a line item on the financial statements as opposed to in the notes to the statements [FASB, Statement of Financial Accounting Concept No. 5, "Recognition and Measurement in Financial Statements of Business Enterprises" (Stamford CT: FASB, 1984), Paragraph 6.]

Companies should recognize items when (and only when) they have met the following four criteria.

1. The item meets the definition of one of the elements of the financial statements. For example, before a company records an asset, the item must meet the definition of an asset.

2.  The item is measurable. Events that are relevant to decision making are recognizable only if the firm can measure them. Consider an entity that has been sued. In the early stages of the lawsuit, it may not be possible to reliably estimate the amount of the potential obligation. Therefore, it does not report a liability on the balance sheet.

3.  The item must be reliable. This notion is similar to the faithful representation characteristic discussed earlier in that reliable financial information depicts the substance of an economic event in a manner that is complete, neutral, and free from error.

4.  The item is relevant. That is, it must allow financial statement users to make rational economic decisions.

An item could meet all four of the above criteria and still not be recognized due to the cost-benefit constraint or materiality threshold. Similar to the cost constraint that standard-setters apply when setting accounting standards, companies use the cost-benefit constraint when determining when to recognize an item in the financial statements. The cost-benefit constraint requires that the expected benefits from recognition exceed the cost of recognition. Reporting the individual wages and salaries for 2,500 employees worldwide in a company may be more useful in certain analyses than simply reporting total wage end salary expense on the income statement. However, the cost of providing that information will probably exceed its benefit.

The materiality threshold requires that an item be recognized in the financial statement if its omission or misstatement would significantly influence the judgment of a reasonably informed statement user. Materiality can apply to a numerical value or a nonquantifiable concern. For example, a company facing an antitrust violation has no amounts to report because the litigation is still in process. However, the firm must disclose the litigation to ensure its financial statements are transparent.

Revenue and Expense Recognition

The financial markets' emphasis on reported earnings makes revenue and expense recognition principles important. Recall from an earlier post that Johnson & Johnson beat analysts' forecasts in the fourth quarter of 2016. The ability to report earnings in line with or higher than forecasts can be critical to a company's stock price. The intent of the revenue and expense recognition principle is to recognize revenue and expenses in the appropriate time period.

The revenue recognition principle in the conceptual framework [The Conceptual Framework (or “Concepts Statements”) is a body of interrelated objectives and fundamentals. The objectives identify the goals and purposes of financial reporting and the fundamentals are the underlying concepts that help achieve those objectives (fasb.org.)]states that a company should recognize revenue when it is realized or realizable and earned:

1. An item is realized or realizable when a company exchanges a good or service for cash or claims to cash.

2.  Revenues are considered earned when the seller has accomplished what it must do to be entitled to the revenues.

A new revenue standard, which public companies started adapting in 2017, was not completely aligned with a conceptual framework. That is, the new revenue standard indicated that the overarching principle of revenue recognition was the notion of the transfer of control of the goods or services. Five steps are applied to determine the timing and measurement of revenue:

1. Identify the contract with the customer.

2. Identify the separate performance of obligations in the contract.

3. Determine the transaction price.

4. Allocate the transaction price to separate performance obligations.

5. Recognize Revenue when each performance obligation is satisfied.

Expense recognition principles are used to determine the period when a company reports an expense on the income statement. Firms recognize expenses when:

1. The entity's economic benefits are consumed in the process of producing or delivering goods or rendering service.

2.  An asset has experienced a reduced (or eliminated) future benefit, or when a liability has been incurred or increased, with an associated economic benefit.

Therefore, a company reports an expense when economic benefits are consumed. There are three main approaches to determine when to report an expense:

• Match with revenues

• Expense in period incurred

• Systematically allocate over periods of use

The approach used depends on the type of expense. For example, some expenses---such as cost of goods sold---consume inventory when used and are matched with their related revenues. Specifically, firms match the cost of goods sold expense directly with the sales of inventory, during the same period. Firms can also record expenses in the period which they are incurred. For example, the salary of a staff accountant is recorded in the period worked. Finally, firms systematically allocate some expenses over the period during which the related asset provides benefits. For example, a firm depreciates (i.e., expenses) a building over the periods that it will provide a benefit to the entity.

Commonly, firms reduce an asset or increase a liability when expected future cash flows change. For example, in the period that a company determines it can no longer sell certain inventory, it will record a loss on the income statement and write the inventory down on the balance sheet. Exhibit 2.9 summarizes these examples. 

EXHIBIT 2.9 Examples of Expense Recognition

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 36-38*

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