Generally Accepted Accounting Principles are composed of a broad conceptual framework so that rules and methodology can be applied to any business or industry. While these broad rules help create flexibility in the accounting system, they also can be nebulous. The recognition of revenues and expenses are a good example.
Statement of Financial Accounting Concepts Number Five, called SFAC 5, outlines four standards to recognition: adherence to conceptual definitions, measurability, relevance and reliability. Revenues are inflows or improvements to assets as the result of providing goods or services through the company’s operations. GAAP defines expenses as outflows of assets or incurred liabilities in connection with the production of product or providing services. Revenues are usually measured by the price of the product or service sold and expenses, the cost to receive products or services. Relevance and reliability require that reporting a revenue or expense is useful and accurate for those making financial decisions.
SFAC 5 gives additional guidance for recognizing revenues. GAAP requires that revenues be realized or realizable and earned. Realizable means that you have collected assets or can lay claim on assets in exchange for goods or services. For revenue to be earned, a product or service must have been completed. Revenue is not always earned at the time of sale. Long-term construction contracts, like those for large aircraft manufacturing, will require special recognition methods. Recognition of revenue and expenses for these long-term contracts will be based on the percentage the contract has been completed or when the contract has been fulfilled.
An expense is recognized when an economic benefit is used up in producing a good or service. For example, if your business bought office supplies, the payment of cash for those supplies does not satisfy the recognition requirement. It is not until those supplies are taken out of a supply room and used, that a company records the expense.
Special consideration must be given to how revenues and expenses are related. Recall that an expense is the using up of an economic resource to generate a product or service. Those products and services will later be sold and recognized as revenue. GAAP has established a special rule for this relationship known as the matching principle. The matching principle requires that expenses must be recognized in the same period as the related revenues.