Revenue Recognition and Expense Recognition - Online Tutor, Practice Problems & Exam Prep

Revenue is recognized when goods or services are delivered, reflecting the value earned from transactions. The revenue recognition principle under GAAP mandates recording revenue upon delivery, regardless of cash payment timing. Conversely, expenses are recorded using the matching principle, aligning them with related revenues in the same period. This ensures accurate financial reporting, reflecting the costs incurred to generate revenue. Understanding these principles is crucial for effective financial management and accurate accounting practices.

Revenue Recognition Principle

Alright. So now let's dive a little deeper into when we recognize revenue, which means recorded on our books, and also recognize expenses in GAAP. Right? When does GAAP require us to record revenue and expenses? Let's check it out.

So let's start here with revenue. And remember that revenue is the value of goods or services that we provide, right? So when we provide a good or service to our customer, we earn revenue, right? And revenue is the money that comes in from that. And the selling of these goods and services, well that's why we're in business, right? That's the whole point. And this revenue is related to why we're in business. If we sell t-shirts, and we're a t-shirt company, well that revenue comes from selling t-shirts, right? So that's a distinction I just want to make: that when you're a t-shirt company and you sell t-shirts, that's revenue. But compare that to if you're a t-shirt company and you have some machine that you use to produce t-shirts and you sell that machine, well, you're not in the business of selling machines, right? That's going to be something different. That's not technically revenue when we sell something that's not related to our business.

Okay. So these goods and services are the reason we're in business. And these revenues, well, they're generally just cash inflows from customers. But sometimes we sell things to customers on account, right? And we have accounts receivable, things like that. There are other ways to earn the revenue, but most of the time, we're just going to get cash. So the revenue recognition principle, and this is GAAP. GAAP tells us this and requires us when and how to record revenue. It comes from this revenue recognition principle. So let's see what it says.

When do we record revenue? Well, revenue is recorded when it is earned based on GAAP. Okay? So what does that mean? Well, revenue is earned when the business has delivered its end of the bargain. Okay. Its end of the bargain. So with that t-shirt company, right? When the customer has the t-shirt in their hand and you hand it to the customer, that's when you deliver, right? Regardless of if the customer is going to hand you cash right now or give you an IOU to pay you in the future, you've done your part of the transaction, right? You gave the customer the t-shirt, well your job is done. Just like with a tutoring company, let's say because it's a service not a physical product. Well, with a tutoring company, when the tutoring session is done, right? Regardless of if the customer is going to pay you at the end of the session, or pay you in advance, or pay you later, you earn the revenue when that tutoring session is finished, right? That one hour, two hours past, you've earned the revenue. Okay?

So how much revenue do we record? Well, the amount of revenue we record is the value of the good or service provided to the customer. Right? And generally, it's pretty easy to think how much revenue record. It's whatever the customer paid for it. What did the customer pay for it? That's the amount of revenue. Okay? So if they paid $10 for the t-shirt, we get $10 of revenue. If they paid $50 for the tutoring session, you get $50 of revenue, right? So you just find the value of what you provided to the customer and what they gave to you, that is the revenue. Cool?

Alright. So let's pause right here and then we'll continue with the expense recognition principle, right? Let's do that now.

Expense Recognition - The Matching Principle

Alright. So let's continue here with expense recognition. And remember that expenses are the value of goods and services that the company receives. Compare that to revenue. When it comes to revenue, we are providing services to others. With expenses, we're receiving services from others, okay? Generally, what's going to happen is we need to incur expenses to earn revenue, right? There are various expenses we need: we're going to need salespeople, people at the cash register, tutors, and all sorts of other expenses to be able to sell the product to the customer, okay? What we use in GAAP is what's called the matching principle. The matching principle tells us when to record expenses. So, we have the revenue recognition principle for revenue and the matching principle for expenses. When do we record expenses? This is the whole concept behind matching. Expenses are recorded in the same period as their related revenues. The idea here is that we're matching the expenses to the revenues. This makes sense, right? We earned this revenue in this period, and what we want to know is, during this period, what did it cost us to earn that revenue? If we sold these T-shirts, what did it cost us during this period? So, we want to consider all the expenses during the period that we earned the revenue as the expenses for that period. Generally, we want to think about when we receive the benefit. Think about when we receive the benefit, and that's when we need to record the expense. As we continue, we are going to see some examples of different expenses and when to record them. But just as an example, let's say you paid for a rental agreement for a whole year. If we are just considering the first month of the rental agreement, we don't want to include the whole expense of the whole year, right? We only want to include the one month that has passed, right? We want to match when we earn or when we receive those benefits. The benefits of renting the space and using the space, we want to take those expenses as they come. So, we would take one-twelfth of the expense each month throughout the year. We will see more details about that, but the idea here is just matching those revenues with the expenses. So, we want to take the expense when we receive the benefit.

I want to make a quick note about expenses here. It's important to realize that we don't always pay cash, right? Some expenses are going to be paid in cash. Maybe we just had employees work for two weeks, and then we paid them, and the expense came up, and we paid them, right? And we have the cash, the expense, right there. But other times, it's not just about paying for something with cash. Sometimes we are using up an asset, such as supplies. So, we might have a supply closet full of office supplies: pens, papers, notepads, clipboards, whatever. And throughout the year, we are grabbing stuff out of the closet and using it up. Well, we have to take an expense for all the stuff that we used up, since we used it during this period, and we received the benefit of using those supplies during this period. Then we have to take the expense this period. So, some are paid in cash, some are used up from an asset, and sometimes, we create a liability. Sometimes, we receive the benefit for something, but we haven't paid for it yet. So we will have to create a liability for that. And I just want to note that it's the occurrence of the event, that event being us receiving some sort of benefit, that causes the need for the expense record, okay? It has nothing to do with the cash outflow. And that's the whole difference between accrual accounting and cash basis accounting. Well, sometimes it does line up with the cash, but not always. Sometimes we have things like this where we are using up an asset, creating a liability, things like that. Alright? So let's pause here and then try this practice problem on the page.

From an accrual accounting perspective, label the following events as an expense or not an expense:

• An employee works all week for the company:

•The company pays the employee for the past two weeks of work:

•The company occupies a space for a month

•The company pays for a year's worth of rent

Alright. Let's try this practice problem. From an accrual accounting perspective, label the following events as an expense or not an expense. Okay? So this is kind of interesting. So let's think about when the employee works all week for the company. Okay? So I want to know these; they're going to go two and two here. Okay? So something I want you to know. What is the triggering event for the expense? When the employee works all week for the company? Or when the company pays the employee for the past two weeks of work? So which one is the expense there? The expense is going to be when the employee works, right? That's us receiving the benefit of the employee working for us. So this is going to be the expense right here, is when the employee works for us. We're literally going to take the expense. And we might see some kind of journal entry like debiting wage expense, right, to increase the expense. And we would credit, a liability like wages payable, right? That payable tells us it's a liability and we would have some amount, right? Based on the amount that they earn during that week, so we would create a liability there and then the company pays the employee for the past two weeks of work, Right? So when we pay the employee for the past two weeks of work, well, that alone is not an expense. Right? This is just the movement of cash. So that would have some sort of journal entry. Let me do it in blue, so it's separate. This entry might look something like this where we have a decrease in the wages payable. So this is a debit to wages payable and then a credit to cash, right? Because we're paying them in cash. So notice the difference there. The expense arises from the employee working for us, not from us paying the employee, right? So the expense goes up because he worked for us and then we just pay him and that gets rid of the liability of having to owe him money, Okay? So let's consider the same thing with the next two. We have the company occupies a space for a month, and then the company pays for a year's worth of rent. So which one do you think triggers the expense here? Well again, it's going to be this first one, right? This first one is the expense because this is us receiving the benefit, right? We're in the space. We're using the space. Whatever it is, the factory to create our product. So we're getting a benefit. Right? We earn we have the benefit of using the space and that creates the expense. Rent expense. And we would credit, you know, rent payable or something like that. Okay? So we would have to pay the rent and that's that separate from us actually using the space. Us using the space creates the expense, and it makes us have to be liable to pay for it, right? And then we pay for it. So when we do pay for it, well, we're going to get rid of our payable or we're going to create some sort of asset for prepaid rent if we if we paid rent in advance. Either way, the payment itself is not an expense. Okay? The payment itself is just the outflow of cash. Okay? This is just the movement of cash. It doesn't by itself create an expense, and that could be something like we we debit, rent payable. Right? We might have had some rent we had to pay, and then we credit cash because we paid in cash. So notice where the expenses line up. The expenses are here in this entry and here in this entry, right? And that those are the entries where there's some sort of event where we're getting a benefit. Right? An employee working for the company, we get a benefit there. The company occupying a space, we're getting the benefit there, right? So we got to take those expenses. Compare that to the other two where we're just paying cash, right? And that's just the movement of cash, which is separate, okay? So that's the big difference between how we deal with things in accrual accounting, right? Is where it doesn't just matter where the cash is moving, we think about the event where we get the benefit or we provide the benefit for revenues. Cool? Alright. So let's go ahead and move on to the next video.

A company has provided you with the following information about January's income.  If the company uses a cash basis of accounting, what is their net income for the month of January?

• A. $600
• B. $1,000
• C. $1,400
• D. $1,600
• E. None of the above

If the company uses an accrual basis of accounting, what is their net income for the month of January?

• A. $600
• B. $1,000
• C. $1,400
• D. $1,600
• E. None of the above

Here’s what students ask on this topic:

What is the revenue recognition principle under GAAP?

The revenue recognition principle under GAAP (Generally Accepted Accounting Principles) states that revenue should be recognized when it is earned, regardless of when the cash is received. This means that revenue is recorded when the business has delivered its end of the bargain, such as providing a good or completing a service. For example, a t-shirt company recognizes revenue when the t-shirt is handed to the customer, even if the payment is received later. This principle ensures that financial statements accurately reflect the company's earnings during a specific period.

When should expenses be recorded according to the matching principle?

According to the matching principle under GAAP, expenses should be recorded in the same period as the related revenues. This means that expenses are recognized when the benefit is received, not necessarily when the cash is paid. For instance, if a company incurs costs to generate revenue in a particular period, those costs should be recorded as expenses in that same period. This principle ensures that financial statements accurately reflect the costs associated with generating revenue, providing a clear picture of the company's financial performance.

How does the matching principle differ from cash basis accounting?

The matching principle, used in accrual accounting, requires expenses to be recorded in the same period as the related revenues, regardless of when the cash is paid. In contrast, cash basis accounting records expenses only when cash is actually paid. For example, under the matching principle, if a company uses office supplies in January but pays for them in February, the expense is recorded in January. In cash basis accounting, the expense would be recorded in February. The matching principle provides a more accurate representation of a company's financial performance by aligning expenses with the revenues they help generate.

What are some examples of expenses that are not paid in cash?

Examples of expenses that are not paid in cash include using up assets and creating liabilities. For instance, a company might use office supplies from its inventory, which is an expense recorded when the supplies are used, not when they are purchased. Another example is accruing wages for employees who have worked but have not yet been paid; this creates a liability. These expenses are recognized when the benefit is received, ensuring accurate financial reporting under the matching principle, even if no cash transaction occurs at that time.

Why is understanding revenue and expense recognition important for financial management?

Understanding revenue and expense recognition is crucial for effective financial management because it ensures accurate financial reporting. Recognizing revenue when it is earned and matching expenses to the related revenues provides a clear picture of a company's financial performance. This accuracy helps in making informed business decisions, assessing profitability, and maintaining compliance with accounting standards like GAAP. It also aids in financial planning and budgeting, as it reflects the true costs and earnings within specific periods, enabling better resource allocation and financial strategy development.