Cash and accrual accounting have some rather striking differences, and none are more apparent than the way each method of accounting recognizes revenue. But for accrual accounting, and more specifically, accrual accounting that follows Generally Accepted Accounting Principles (GAAP), sweeping changes are happening for companies around the world.
Before we dive in, let’s take a step back and talk about what revenue recognition means in both cash and accrual accounting. Cash accounting allows businesses to recognize, or account for, revenue when payment has been received. If a customer pays you $1,000 for interior design services that won’t be delivered for 2 months, it doesn’t matter. The business is required to recognize or account for revenue as soon as cash is in hand.
Accrual accounting that follows GAAP accounting principles takes a different approach. Revenue is recognized not when payment is received, but when a revenue-generating event has occurred. Let’s say you receive the $1,000 upfront payment from a customer. You start providing the interior design services 2 months later, and continue across a 6-month period. That means the payment will be recognized as revenue as soon as your business starts providing the service, and that revenue will be divided over the time period (6 months) when you provided the service.
GAAP revenue recognition presents several key challenges.
The GAAP revenue recognition principle makes sense in theory, but in practice, it can create conditions that are not favorable for businesses. Let’s say the interior design firm mentioned above signs a contract with a client that does not include an upfront payment. The firm begins work on the project and starts recognizing revenue because revenue-generating events are happening, but no there’s no cash coming in. On paper, the business looks favorably as it is recognizing revenue, but there’s a cash deficit.
That conflict between cash reserves and recognized revenue can make financial statements difficult to evaluate – and that’s not the only issue. Until quite recently, GAAP revenue recognition requirements were different per industry. So if you are an investor trying to evaluate the financial viability of several companies, GAAP revenue recognition actually makes it more complicated. Media companies, automotive manufacturers, and financial services firms all have differing applications of the GAAP revenue recognition principle.
Don’t get us wrong: GAAP accounting is still a widely accepted standard among businesses, and the structure it provides makes financial statements a lot more comparable than they could be. However, GAAP revenue recognition has had a makeover in recent years that makes it much easier to compare one business to another.
So what’s happened to GAAP revenue recognition?
In May of 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) announced a change to GAAP revenue recognition as it relates to customer contracts, under the title of Accounting Standards Codification (ASC) 606. In essence, the new GAAP revenue recognition requirements provide a more uniform standard of revenue recognition across all entities, improved disclosure of information for those consuming financial statements, and a reduction in requirements for simplification purposes.
Here’s a visual describing the impact on customer contracts from FASB’s revenue recognition page:
So how does this process differ from what was happening before? Prior to the launch of ASC 606, there were all kinds of exceptions to this rule. Media companies had special revenue recognition rules for license revenue. The automotive industry treated many differing types of revenue, like rebates, repurchase options, and product warranties, all the same.
With ASC 606, the rules have changed to consistently apply a uniform revenue recognition principle across a wide variety of entities in the same way. In many cases, businesses include events in contracts that are not performance obligations, like reselling products, services, or warranties. Those items will be excluded from GAAP revenue recognition going forward.
The impact of changes to GAAP revenue recognition will take a bit to understand, as businesses work to comply and investors consume the new format. In the long term, expect the GAAP financial statements of all companies to become more easily comparable – regardless of their industry.