By William Pirraglia
GAAP stands for Generally Accepted Accounting Principles and is used by every major corporation in the U.S. The United Kingdom and most European countries have similar standards of accounting for business operations. Whether you’re a business owner, investor or just someone who would like to better understand how financial income data is recorded, this brief explanation should be helpful.
In 1973, the Financial Accounting Standards Board (FASB) was created as a private, not-for-profit entity to standardize accounting rules for all businesses. Its mandate was to improve the accounting for business operations whenever necessary. The Securities and Exchange Commission, as part of its regulation of stocks and securities, has the power to issue rules for accounting, but defers to FASB for most accounting regulations.
Revenue recognition rules are one of the most important standards of GAAP. Unlike the world of many small businesses, the larger corporate universe seldom receives revenue (income) as cash. From installment sales to futures contracts, to selling internationally on credit, revenue comes in many flavors and is seldom received at the time of sale. GAAP sets revenue recognition rules to level the playing field and provide accurate data to investors and the public in general.
Take nothing for granted, including revenue recognition levels reported by large corporations. Just remember some of the financial disasters of the early 21st century, such as Enron, which resulted in the disappearance of some major corporations, primarily because of reporting inaccurate revenue figures, either accidentally or intentionally. If you’re considering investing in a company, always read the most recent audit report compiled by its independent CPA firm.
GAAP revenue recognition rules are straightforward and relatively simple. Revenue is recognized when a transaction happens that results in income that is (a) realized and (b) earned. For example, company A sells a product to company B for $1,000. Company B promises to pay for the product within 30 days. The revenue can be recorded on the date of sale with the understanding that the cash will be received in the future. Most companies put these terms in writing, as oral agreements can be difficult to substantiate should the transaction not be completed as agreed.
Companies sell many products and services on credit, generating accounts receivable (agreements to remit the purchase price in the near future) or notes receivable (promises to pay monies due in the short- or longer-term future). In both cases, the companies earning this revenue record the income at the time of sale, not when the payment is received. Therefore, their cash position may or may not reflect the volume of their current sales. GAAP permits this revenue recognition program because the income was earned, although not received, on the date of the sale.