GAAP refers to US accounting standards established by the Financial Accounting Standards Board. GAAP revenue recognition rules require revenue to be realized or realizable and earned before it can be recorded. These rules apply to accrual basis accounting and have been developed to prevent fraudulent or overinflated income statements.
Generally Accepted Accounting Principles, or GAAP, refers to a set of United States accounting standards established by the Financial Accounting Standards Board. With respect to GAAP revenue recognition, this is a standardized set of rules that deals with how and when revenue is recorded in the organization’s accounting. Revenue must, under GAAP, meet certain standards before it can be recorded and listed in financial statements, a process known as revenue recognition.
The Financial Accounting Standards Board outlines two specific criteria regarding GAAP revenue recognition. First, before revenue recognition can occur, the revenue must be realized or realizable. Realized means that cash has been received, while realizable means that a promise to pay has been received. Next, revenue must be earned, which means that the organization offered something in exchange for the revenue, such as a product or service. Both of these qualifying criteria must be met before an organization can recognize revenue and record it in the financial statements as revenue.
Typically, GAAP revenue recognition rules apply to accrual basis accounting, rather than cash basis accounting. Accrual accounting records transactions as they occur, regardless of when cash is exchanged. For example, when a pharmacy delivers medication to a patient, the pharmacy generates revenue, even if the business must wait for a patient’s insurance company to pay. Similarly, the pharmacy incurs expenses for drug supplies, even if the pharmacy has not yet paid the bill for a drug shipment.
Under GAAP revenue recognition standards, a business cannot record revenue until a transaction is completed and the revenue is officially earned. In other words, the pharmacy in the example above cannot record revenue from filling a prescription until the patient completes the transaction by picking up the order. If the patient participates in an automatic refill program, for example, the pharmacy cannot record revenue from future transactions until each prescription is filled and delivered to the patient.
Although GAAP revenue recognition rules may seem simple, a variety of transactions do not imply a clear point of revenue realization. Franchise fees, retainer contracts, billing and retainer orders, and other transactions can easily cloud the point at which an organization can recognize revenue generated. While GAAP rules are intended to be flexible to accommodate the needs of a variety of business models, the ambiguity has led to a misunderstanding regarding the spirit of the rules.
Numerous high-profile cases were reported in the late 1990s, all involving publicly traded companies misapplying GAAP revenue recognition rules to inflate income statements. As such, the Financial Accounting Standards Board has developed numerous specialized management rules in an effort to prevent fraudulent or overinflated income statements. In addition, the Securities and Exchange Commission, or SEC, helped enact various laws to regulate the accuracy of financial statements and managerial responsibility regarding revenue recognition.
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