Revenue Recognition

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. 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 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.

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.

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 be 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.

Reference

Kieso, D., Weygandt, J., & Warfield, T., (2007) Intermediate Accounting (12th ed.). New Jersey: John Wiley & Sons.