While small businesses sell many different products and services, the accounting cycles within these businesses are generally the same. For many companies, the revenue cycle is one of the most important, as it provides the revenue that keeps the company in business. Understanding the accounts that are generally included in the revenue cycle can help you learn about how revenue flows throughout your company's accounting system.
As expected, the main account in the revenue cycle is the revenue, or sales, account. Generally accepted accounting principles have set strict criteria for the recognition of revenue. While some types of transactions have even more rules, all transactions require four characteristics to be met before revenue can be booked. First, the price must be fixed or determinable. Second, delivery of the product must be assured or services must have been rendered. Third, there must be persuasive evidence that a sales arrangement exists. Finally, collectibility must be reasonably assured. If any one of these qualities does not exist for the transaction, revenue may not be booked.
Accounts receivable are claims that the company has against other entities for the delivery of assets at a future date. For most small businesses, accounts receivable mostly consist of sales to customers on credit. Small-business owners should be cautious when making credit sales. While it would be wonderful if every customer paid his bills on time, that isn't always the case. If credit sales are the norm in your industry, you should have a rigorous process in place to determine who is granted credit. In addition, the credit check that you make of a customer when making an initial credit decision should not be your last. Accounts receivable personnel should be watching for signs of impending insolvency. Slow payment, not taking trade discounts and smaller new orders could all be signs that your customer is not as creditworthy as he used to be.
Generally accepted accounting principles require that the financial statements may only show the amount of accounts receivable that the company will be able to eventually collect. While this number is unknown, it can be estimated. The allowance for doubtful accounts is a company's best guess of the amount of the accounts receivable balance that will not be collected. Most companies apply a two-pronged approach to the allowance. First, the company identifies balances that it believes are not going to be collected on. This may include companies that have filed for bankruptcy or haven't paid in a while. Then, the company usually reserves an additional percentage of the account based on the age of the receivable. For example, a company may determine that, historically, it is only able to collect on 10 percent of receivables more than 120 days past due. As such, it would add 90 percent of the value of 120 days past due receivables to the allowance account.
For companies that sell goods and services on a cash basis, the cash account is part of the revenue cycle. Small-business owners should recognize that just because cash is received, that doesn't mean revenue is earned. For example, a magazine publishing company often will receive funds for an annual subscription up front. However, the company is only allowed to recognize revenue on that subscription as the magazines are delivered. As such, if the subscription is for 12 monthly issues, 1/12th of the revenue would be recognized each month, even though all of the cash is recorded upon receipt. The amount of cash received representing revenue that has not been earned is known as deferred revenue.