Lecture 3: Revenue, Expenses, and Adjusting Entries: Accrual vs. Cash Basis Accounting
Revenue and Expense Recognition Principles
Revenue Recognition: Revenue is recorded when it is earned, meaning the business has substantially completed its obligation to the customer by performing the service or delivering the goods, regardless of whether cash has been received. This aligns with the accrual basis of accounting. Key criteria usually include:
Existence of persuasive evidence of an arrangement: A contract or agreement is in place.
Delivery has occurred or services have been rendered: The product or service has been transferred to the customer.
The seller's price to the buyer is fixed or determinable: The amount of revenue can be reliably measured.
Collectibility is reasonably assured: There is a high probability of receiving the payment.
Expense Recognition: Expenses are recorded when they are incurred or used to generate revenue, regardless of when cash is paid. This is often referred to as the matching principle, which dictates that expenses should be recognized in the same accounting period as the revenues they helped to generate. For example:
Rent paid for a future period is initially recorded as a prepaid asset and expensed over the period it is used.
Salaries are expensed in the period employees work, even if paid later.
Depreciation expense is recognized over the useful life of an asset, matching its cost to the periods of revenue generation.