Why revenue recognition is a significant issue
Businesses exist in order to make profits that arise from the sale of products or services. It then becomes necessary to determine when a sales transaction should be recognized in the books of accounts of the business. In accounting, the revenue recognition principle states that revenue should only be recognized when the service is offered, or when the goods have been dispatched to customers and not necessarily when cash is received (Hermanson & Edwards, 2005).
For purposes of accounting, revenue is only recognized in the books when the following incidents have occurred:
- The sale is of a quantity of goods that is known for certain, and the selling price is also known; so that the transaction value is known.
- When the sales transaction has been concluded, or it is known with a reasonable degree of certainty that it shall be concluded.
- When a critical incident in the sales transaction with the buyer has occurred, e.g. when a customer makes a promise to pay, and the transaction is legally enforceable.
Difference between a product and period expense
Expenses are the costs incurred in the business in the course of its operations. Product expenses are the direct costs of production, including the costs of raw materials, direct labor and variable overhead costs. Period expenses, on the other hand, are those expenses that cannot be directly attributed to the product or service produced. They are related mainly to the general administration or selling and distribution of the products created and are offset against the profit of the business during the accounting period when they were incurred.
Matching concept of accounting
This is also called the accrual concept. It states that the revenues and expenses of an organization must be recognized as they are earned or incurred and not necessarily when cash exchanges hands. It further states that the incomes for a period should be matched with the expenses for the same period and charged to the profit and loss account for the period to which the incomes were earned or when the expenses were incurred so far as the relationships between the incomes and expenses can be established or can be assumed in a justifiable way.
Matching concept is also applied when accounting for the inventory of the organization. Only the sold inventory should be accounted for in the income statement, both in terms of revenue and costs of sale. The cost of sales is accounted for as follows in accordance with the matching concept:
Cost of sales = Opening stock + Purchases – Purchase returns – closing stock.
Time period
Time period refers to the time lag between the dates of financial reporting of a company. Apple Company is a consumer electronics corporation based in Cupertino, in the United States. The time period for Apple Company is 12 months; with quarterly reports being produced every three months. The fiscal year for Apple Company ends on 30th September of every year.
Samsung Electronics Company Limited is a South Korean company with its headquarters in Suwon, South Korea. The time period for Samsung Electronics is 12 months or one year. Its financial statements are normally prepared for the year ending 31st December every year. However, quarterly reports for the company are usually produced every three months of operation.
Preparation of the financial statements for both companies is done as per the International Financial Reporting Standards (IFRS), mainly for the purpose of harmonization of reporting with that of other companies across the globe. Auditing in both companies is carried in accordance with the International Standards on Auditing where external auditors express an opinion on the validity of the financial statements. The external auditors of Apple Company are Ernst and Young whereas those for Samsung are Samil PriceWaterhouseCoopers.
Changes in income statement items
An analysis of some of the income statement items for the two companies is as shown on the excel worksheet. The items include sales revenue, cost of goods sold, total operating expenses, operating income and the net incomes after taxation.
For Apple Company, there was a 9.2% increase in revenues between 2012 and 2013. However, the cost of sales increased by 21.36%, which was a more than a proportionate adverse increase in the costs of selling expenditure. Operating expenses increased by 14.3%; leading to a reduction in total operating profits by 11.3% and net income after taxes by 11.25%. Despite the increase in total revenue for the company, its overall performance in the year 2013 was poor due to the inefficiencies in reducing the costs of sale and operating expenditure.
Samsung Electronics Company Limited, on the other hand, had an increase in revenues by 13.7%. The costs of sales increased by 8.7%; which is a less than a proportionate favorable increase in costs of sales expenditure. The total operating expenses increased by 19.4%, resulting in increased operating income and net income after taxation by 26.6% and 27.8% respectively. This is an improvement in performance of the company from the previous year’s performance.
Looking at the overall performance of the two companies, Samsung Electronics Company Limited can be said to have a better performance than Apple Company, mainly due to the overall increase in net profits of the company as opposed to the decrease in profits witnessed in Apple Company.
Reference
Hermanson, R. H., & Edwards, J. D. (2005). Financial accounting : a business perspective. Minnesota: Freeload Press.