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Explain the revenue recognition principle.

Short Answer

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The revenue recognition principle under generally accepted accounting principles provides guidance that a firm should recognize revenue when it is realized or realizable and when it is earned.

Step by step solution

01

Definition of Revenue Recognition Principle

The revenue recognition principle as developed by Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) indicates that the companies recognize revenue in the accounting period when the performance obligation is satisfied.

02

Explanation of Revenue Recognition Principle

The revenue recognition principle under current generally accepted accounting principles provides that companies should recognize revenue when it is realized or realizable and when it is earned. Therefore, proper revenue recognition revolves around three terms:

  • Revenues are realized when goods and services are exchanged by the company for cash or receivables.
  • Revenues are realizable when assets received in exchange by the company are readily convertible to cash or receivables.

Revenues are earned when a company has gradually achieved what it must do to receive the benefits represented by the revenues- means when the earning process is complete or is about to be completed.

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Most popular questions from this chapter

The life of a business is divided into specific time periods, usually, a year, to measure results of operations for each such time period and to portray financial conditions at the end of each period.

  1. This practice is based on the accounting assumption that the life of the business consists of a series of time periods and that it is possible to measure accurately the results of operations for each period. Comment on the validity and necessity of this assumption.
  2. What has been the effect of the practice on accounting? What is its relation to the accrual system? What influence has it had on accounting entries and methodology?

Question: Daniel Barenboim sells and erects shell houses, that is, frame structures that are completely finished on the outside but are unfinished on the inside except for flooring, partition studding, and ceiling joists. Shell houses are sold chiefly to customers who are handy with tools and who have time to do the interior wiring, plumbing, wall completion and finishing, and other work necessary to make the shell houses liveable dwellings.Barenboim buys shell houses from a manufacturer in unassembled packages consisting of all lumber, roofing, doors, windows and similar materials necessary to complete a shell house. Upon commencing operations in a new area, Barenboim buys or leases land as a site for its local warehouse, field office, and display houses. Sample display houses are erected at a total cost of \(30,000 to \)40,000 including the cost of the unassembled packages. The chief element of cost of display houses is the unassembled packages, in as much as erection is a short, low-cost operation. Old sample models are torn down or altered into new models every 3 to 7 years. Sample display houses have little salvage value because dismantling and moving costs amount to nearly as much as the cost of an unassembled package.Instructions

  1. A choice must be made between (1) expensing the costs of sample display houses in the periods in which the expenditure is made and (2) spreading the costs over more than one period. Discuss the advantages of each method.
  2. Would it be preferable to amortize the cost of display houses on the basis of (1) the passage of time or (2) the number of shell houses sold? Explain.

Question: An accountant must be familiar with the concepts involved in determining earnings of a business entity. The amount of earnings reported for a business entity is dependent on the proper recognition, in general, of revenues and expenses for a given time period. In some situations, costs are recognized as expenses at the time of product sale. In other situations, guidelines have been developed for recognizing costs as expenses or losses by other criteria.Instructions

  1. Explain the rationale for recognizing costs as expenses at the time of product sale.
  2. What is the rationale underlying the appropriateness of treating costs as expenses of a period instead of assigning the costs to an asset? Explain.
  3. In what general circumstances would it be appropriate to treat a cost as an asset instead of as an expense?
  4. Some expenses are assigned to specific accounting periods on the basis of systematic and rational allocation of asset cost. Explain the underlying rationale for recognizing expenses on the basis of systematic and rational allocation of asset cost.
  5. Identify the conditions under which it would be appropriate to treat a cost as a loss.

Selane Eatery operates a catering service specializing in business luncheons for large corporations. Selane requires customers to place their orders 2 weeks in advance of the scheduled events. Selane bills its customers on the tenth day of the month following the date of service and requires that payment be made within 30 days of the billing date. Conceptually, when should Selane recognize revenue related to its catering service

Question: Comment on the appropriateness of the accounting procedures followed by Cramer, Inc.

a. Depreciation expense on the building for the year was \(60,000. Because the building was increasing in value during the year, the controller decided to charge the depreciation expense to retained earnings instead of to net income. The following entry is recorded.

Retained Earnings 60,000

Accumulated Depreciationโ€”Buildings 60,000

b. Materials were purchased on January 1, 2017, for \)120,000 and this amount was entered in the Materials account. On December 31, 2017, the materials would have cost \(141,000, so the following entry is made.

Inventory 21,000

Gain on Inventories 21,000

c. During the year, the company purchased equipment through the issuance of common stock. The stock had a par value of \)135,000 and a fair value of \(450,000. The fair value of the equipment was not easily determinable. The company recorded this transaction as follows.

Equipment 135,000

Common Stock 135,000

d. During the year, the company sold certain equipment for \)285,000, recognizing a gain of \(69,000. Because the controller believed that new equipment would be needed in the near future, she decided to defer the gain and amortize it over the life of any new equipment purchased.

e. An order for \)61,500 from a customer for products on hand. This order was shipped on January 9, 2018. The company made the following entry in 2017.

Accounts Receivable 61,500

Sales Revenue 61,500

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