In other words, do you show for December $2,000 in revenue and $500 in expenses for a net income of $1,500, or do you show $2,000 in revenue for December and an expense of $500 in January when you pay the salaries of the workers for December? The question then arises: if you recognize the revenue of $2,000 in December, when you run your financial statements for that month, do you include the wages incurred but not yet paid as a cost of doing business that offsets the revenue for that month? For instance, let’s say in the landscaping example above, you hired employees to mow and edge lawns, and you now owe them $500 for services they have rendered (ignore employment taxes for this example.) You’ll pay them in January on the tenth for all work done in December, and then again on February 10 for work done in January, and so on. That’s why the time period concept in accounting is so important, so let’s tackle that next.īecause we cut financial reporting into discrete time periods, usually a year or a quarter, we have to decide when to recognize revenue-in which period. The critical point in this example is not how much you earned, but rather when you report it. Your small landscaping business will likely not be subject to GAAP-in fact, the tax law may require you to report revenues and expenses on a cash basis, but, for publicly traded companies, auditors will only certify financial statements if they have been prepared using the accrual basis of accounting. You do the work, you have earned the revenue, and GAAP requires a company to report that revenue as it is earned. To accrue is to come about naturally-it’s the effect in cause and effect. The term “accrual basis” is based on the idea of accruing revenue, which means reporting it when it becomes a legally enforceable claim. Conversely, if you opt to use a cash basis of accounting, you would recognize and report the revenue in January when you receive it, not in December, even though that’s when you earned it. However, under the accrual basis of accounting, you already accounted for the revenue in December. If you take the entire month of January off, doing no work, but you get paid by all of your December customers, you then have your $2,000 in cash.

This is the gist of the accrual basis of accounting: recognizing revenue as it is earned, as opposed to recognizing it as it is received.

If you were prone to share such information, you could tell your friend that you made $2,000, even if you hadn’t collected any of it yet. On December 31, at a party, an acquaintance asks you about your new business.

In December, you and your crew mow and edge 20 lawns (assume it’s Florida or Arizona.) At each home you leave an invoice for $100 payable within 30 days. You hire a few employees and decide to operate as a sole proprietor for now. Imagine that you start a landscaping business in December. What is the Difference Between Realizing and Recognizing Revenue?.

Colin dodds debit credit theory