Revenue Recognition
Introduction.
The actual fundamental concepts and principles of accounting are outlined in the
Statement of Standard Accounting Practice No.2 under disclosure of accounting policies. There
are four fundamental accounting concepts and principles which are identified and should be
followed when preparing accounts. These four concepts and principles are included in the
company law and companies must follow them when preparing accounts. These concepts are the
accruals, consistency, prudence, and going concern. Chemical and Machinery company ltd
concerns will be limited to the first three concepts and principles only.
Accounting concepts and principles
Accrual is the basis for revenue recognition. It means matching income and
expenditure that occurred within a limited accounting period regardless of whether there was
actual receipt of cash or not. The reasons for these is that the profit for that particular period
should represent fairly all the earnings of the time covered in that period in view of the natural
dynamic nature of any business, it’s highly unlikely that all the invoices will have been paid.
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However, all the invoices for that particular period should be accounted for to give a true picture
of the financial earnings of the company. (Kieso, D., Weygandt, J., & Warfield, T., 2007)
Application
A clear distinction should exist between the receipt of cash and the right to receive
actual cash and between payment of cash and legal responsibility or obligation to pay cash. The
concept of accrual requires that accountants include all sums due and payable as either expenses
or income. Revenue is recognized and entered in accounting records when the goods are
delivered to the client not when he pays for them or when they have been ordered or packed.
The concept of prudence applies when measuring the profit or income. Where sales
are made on credit and it becomes relatively doubtful that the cash will be received then a
provision should be set up for the entire outstanding amount, that’s all the income shouldn’t be
anticipated and all potential losses should be catered for. The valuation method of assets that
give lower values should always be chosen. There should be consistency in all concepts and
principles chosen.
The following changes should be made on the controller’s operating manual. All financial
transactions involving credit sales should be recognized when the consignments have been
delivered to the client not when they have been shipped especially when they are free on board.
Unless the ship belongs to the owner of the consignment the part relating to revenue being
recognized when the consignment has been shipped should be ignored or changed.
The provision for losses should be made immediately the probability of such losses
occurring have been realized. These relates to the production and contracts in progress. The
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consignment in the trailer is still in the company premises as such it’s still part of the company’s
inventory only when they have been delivered to the client, will they be recognized as revenue.
When Chemical and machinery delivered the twenty five street sweepers to the City,
then company should have recognized the transactions. Later they should treat the twenty three
returned street sweepers as sales returns or returns inward. This is because, the delivery and
approval of the trucks is not guaranteed and there is a possibility of the vehicles being resold to
other clients if the city fails to approve and accept them. When the vehicles were delivered to the
city then appropriate entries should have been made in the proper revenue accounts and the
debtors, and the sales ledger accounts respectively. Chemical and machinery cannot wait for the
city to approve the vehicles in order for them to be recognized as earned. (Kieso, D., Weygandt,
J., & Warfield, T., 2007)
The inventory found at the back of a lorry should be included in the closing stock of
the year 2012. The question of being sued as understating the closing and overstating sales
should not arise as it was an error and not as a result of a fraudulent activity.
The twenty three trucks returned from the city should be entered as sales returns as they had
actually been sold before they were returned for minor repairs. The company cannot wait until
the trucks are approved and accepted by the city for them to recognize there sales.
The following measures should be put in place to ensure such events don’t occur
again. The production processes should be properly approved at each step of production. The
invoices and deliveries should be approved by different persons. All loaded vehicles should be
immediately dispatched to their destined destination once they have been loaded.
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When a clause exists regarding delivery orders, the nature of the clause will determine
its treatment in the accounting records. Generally, clauses affect their own company records and
rarely affect the other company. In Chemical and Machinery company, the clause does not affect
the accounting records, they only affect the volume of sales.
The debtors should be invoiced once the deliveries and supporting documents have
been signed and returned to the office. The deliveries made overseas should be treated differently
as most of sales are paid once the ship sets sail. But the entries should be made once the goods
have been received by the client. Other additional measures needed to ensure proper revenue
recognition are timely record keeping and accurate cut off procedures to distinguish one financial
period from the other.
The invoices should be pre-numbered, easy to use, contain all the necessary
information, consistent and contain the serial numbers of their respective deliveries and copies of
them attached to the original invoice. Other controls should include electronic and mechanical
controls of records and other production records including the production processes.
These controls are for instance cash safes, electric fences, cash registers, employee identity
cards, fireproof files and electronic data processing and management information systems.
The following procedures should be put in place to ensure accountability for revenue recognition
within the organization.
All transactions and production activities should be properly authorized to ensure that
all the transactions and activities in the company are in line with the guidelines established to
maintain adequate and consistent courses of action.
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The company should keep adequate production and financial documents records and
take enough measures to ensure their accuracy and consistency. These records should be
analyzed and reviewed from time to time. Measures to counter any variance whether positive or
negative should done properly explained and documented for future reference.
The company should conduct a thorough physical check and exercise diligent control over all the
company assets. This exercise should be done once in a year
The segregation of duties should be done in away as to strengthen the accountability of for
revenue recognition. For instance the person authorizing the sales on credit should not be the one
issuing the invoices or receiving the cheques.
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Reference
Kieso, D., Weygandt, J., & Warfield, T., (2007) Intermediate Accounting (12th ed.). New Jersey:
John Wiley & Sons.
