Companies must follow generally accepted accounting principles, or GAAP, when recording revenue in their accounting books. Not all sales can be booked as revenue at the time when a sale contract is signed. Revenue recording is time-specific in that companies cannot move revenue from one accounting period and record it in another accounting period. Booking revenue that has not been recognized based on GAAP inflates revenue as reported.
Revenue Recognition Rules
According to GAAP, companies cannot book a revenue until they have first recognized the revenue. A revenue is recognized only when it has been earned, and the collection of payment is reasonably assured. GAAP considers a revenue as earned when the related sale has been finalized and the company making the sale has delivered the goods or performed the service. that is, the risk and rewards of ownership have passed to the purchaser.
Companies can recognize a sale as revenue when the rights of ownership have been passed from the seller to the buyer. Booking revenue before recognizing it violates the revenue recognition principle under GAAP.
Unearned Revenue Rules
Certain sales cannot be recognized as revenue at the time of the sale agreements if companies have not fully delivered or performed the goods or service intended for sale to complete the revenue earning process. Companies can receive cash for a sale from customers as prepayments, for example, but such sales proceeds are recorded as unearned revenue in a liability account to be recognized in the future, rather than revenue to add to earnings for the current period. Companies should only book revenue from such sales in subsequent accounting periods as the sales are completed over time.
Basics of Booking Revenue
In addition to potentially booking any unearned revenue, companies might also wrongly book revenue on sales that are completed but don’t belong to the current accounting period. Revenue as a result of sales is recorded in a temporary account in accounting books and must be closed at the end of an accounting period. This ensures that sales completed in the subsequent period are not credited to the revenue account in the current period.
In other cases, companies can transport goods from their point of production to a warehouse in transit before a sale contract is finalized, and book the delivery as revenue despite the possibility that the contract might not eventually go through. These actions are prohibited under GAAP.
Problem With Inflated Revenue
Booking revenue when the revenue has yet to be recognized inflates the amount of revenue for the current reporting period and thus distorts actual earnings. Sometimes, companies that are under pressure to show better earnings might book revenue prematurely as a way to influence reported earnings. The books look good to investors and shareholders but, ultimately, such practices are not allowed under GAAP. In fact, they amount to accounting fraud.
When booking revenue earlier, a company cannot recognize the same revenue later again, essentially creating a time difference between booking revenue and recognizing revenue.
An investment and research professional, Jay Way started writing financial articles for Web content providers in 2007. He has written for goldprice.org, shareguides.co.uk and upskilled.com.au. Way holds a Master of Business Administration in finance from Central Michigan University and a Master of Accountancy from Golden Gate University in San Francisco.