5 Revenue Recognition and Accruals
The Periodicity Problem
Jacqueline Gagnon
The Periodicity Problem
Imagine that a company begins its life with nothing. There are no assets, liabilities, or equity until the owner purchases shares for cash. A company also ends its life with nothing. The shareholders take everything out of the company and dissolve it.
So, a company starts and ends its life with nothing. That makes it easy to calculate the company’s income over its entire life. After all, income is part of equity, and equity is defined by assets and liabilities. Remember:
Assets – Liabilities = Equity
Going further, revenues and gains are increases in assets and/or decreases in liabilities; and expenses and losses are defined as decreases in assets and/or increases in liabilities.
Look at it this way, a generalized business cycle works like this:
[DIAGRAM] PLACEHOLDER [SEE TABLE BELOW FOR DETAILS]
| Business Model Steps | Change in Assets | Change in Income | Sample Transaction | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Assets Give us Expenses… because we use them to create value | Decrease | Decrease | Sell inventory:
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| Expenses make Revenue. This is value creation for the company: revenue is larger than expenses and the remainder belongs to shareholders | No Change | Increase | When we sell Inventory, we also recognize revenue. (No journal entry required here.) |
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| Revenue Gives us Cash. Customers pay in cash now or on account (A/R), which is received in the short-term | Increase | Increase | Sales give us cash from customers:
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| Cash Buys Assets. A company buys assets to expand their business and fund current operations | No change | No change | Purchase inventory with cash:
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And then back to the beginning. The cycle repeats: cash buys assets, then these assets give rise to expenses, and so on…
In this simple example, revenue equals cash received and expenses equal to cash paid for assets. So, if a company starts with zero assets, and dies with zero assets, then net income over the entire life of the company must be:
Net Income over Company Life = Cash Received from Customers – Cash Paid for Assets
Easy right?! And who owns this net income generated over the company’s lifespan? That’s right – shareholders.
The trouble is that companies have to report their net income at least every year. This gives rise to one fundamental issue: assets and liabilities are not equal to zero at fiscal year ends. That’s right, we have valuation issues. In this chapter we will discuss periodicity issues in inventory, prepaid assets, and accrued expensesAccrued Expenses:
Costs of generating revenues are recorded as expenses on the income statement in the period the company benefits from the cost, regardless of whether the cost has been settled in cash.. Periodicity concepts also apply to accounts receivable; property, plant, and equipment (PPE); and long-term loans, but these will be covered in subsequent chapters.