Page 204 - Accounting Principles (A Business Perspective)

5. Accounting theory

Financial Reporting Standards utilize this approach much more than the Generally Accepted Accounting Principles
of the United States.
To learn more about fair market value accounting, visit the AICPA site,

(http://www.aicpa.org/MediaCenter/fva_faq.htm), the source used for the explanation of this topic.

An accounting perspective:

Business insight

In some European countries, the financial statements contain secret reserves. These secret reserves arise
from a company not reporting all of its profits when it has a very good year. The justification is that the
stockholders vote on the amount of dividends they receive each year; if all profits were reported, the
stockholders might vote to pay the entire amount out as dividends. By holding back some profits, not only
are the creditors more protected but the company is also more solvent and has more resources to invest

in productive assets.

Revenue is not difficult to define or measure; it is the inflow of assets from the sale of goods and services to
customers, measured by the cash expected to be received from customers. However, the crucial question for the
accountant is when to record a revenue. Under the revenue recognition principle, revenues should be earned
and realized before they are recognized (recorded).
Earning of revenue All economic activities undertaken by a company to create revenues are part of the
earning process. Many activities may have preceded the actual receipt of cash from a customer, including (1)
placing advertisements, (2) calling on the customer several times, (3) submitting samples, (4) acquiring or

manufacturing goods, and (5) selling and delivering goods. For these activities, the company incurs costs. Although
revenue was actually being earned by these activities, accountants do not recognize revenue until the time of sale
because of the requirement that revenue be substantially earned before it is recognized (recorded). This
requirement is the earning principle.
Realization of revenue Under the realization principle, the accountant does not recognize (record)
revenue until the seller acquires the right to receive payment from the buyer. The seller acquires this right from the
buyer at the time of sale for merchandise transactions or when services have been performed in service
transactions. Legally, a sale of merchandise occurs when title to the goods passes to the buyer. The time at which
title passes normally depends on the shipping terms—FOB shipping point or FOB destination (as we discuss in

Chapter 6). As a practical matter, accountants generally record revenue when goods are delivered.
The advantages of recognizing revenue at the time of sale are (1) the actual transaction—delivery of goods—is an
observable event; (2) revenue is easily measured; (3) risk of loss due to price decline or destruction of the goods has
passed to the buyer; (4) revenue has been earned, or substantially so; and (5) because the revenue has been earned,
expenses and net income can be determined. As discussed later, the disadvantage of recognizing revenue at the time
of sale is that the revenue might not be recorded in the period during which most of the activity creating it occurred.
Exceptions to the realization principle The following examples are instances when practical

considerations may cause accountants to vary the point of revenue recognition from the time of sale. These

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