Realization And Cost Recognition
Robert Littlejohn has just accepted the position of Vice President of Finance and Administration at Simple University. Simple University is a private institution located in Timbucktoo. The institution has an academic year that operates on the trimester basis because a large percentage of the students are nontraditional or international who want to complete their education as quickly as possible.
Mr. Littlejohn reviewed the accounting practices and policies used at the university. During the review, he found, that to simplify accounting, the university records the purchase price of inventory as education expense rather than inventory as soon as the university purchases inventory items for the dining halls and the dormitories. He wants to know if the policy is good accounting procedure or generally accepted accounting principles (GAAP).
The procedure is in violation of the GAAP matching principle. The matching principle is related to accrual accounting and revenue recognition. In some cases it is difficult to determine the period in which an expense contributes to the generation of revenues, but many expenses can be associated with particular revenues. The matching principle dictates that efforts (expenses) be matched with accomplishment (revenues) whenever it is reasonable and practicable to do so. Thus, expenses may be advances (accrued) or delayed (deferred) in a manner similar to revenues. The intent is to match the sacrifices against the benefits in the appropriate accounting period.
According to “Elements of Financial Statements”, FASB Statement of Financial Accounting Concepts No. 6 issued in 1985, expenses are recognized and matched against revenues on the basis of the following principles (paragraphs 146-149):
Simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other event. For example, the sale of a product involves both revenue (sales revenue) for receipt of cash or a receivable and expense (cost of goods sold) for sacrifice of the product or merchandise sold to customers.
Immediate recognition for costs that cannot be directly related to particular revenues and are incurred to obtain benefits that are exhausted in the period in which the costs are incurred. For example, salesmen's monthly salaries and electricity.
Systematic and rational allocation for assets that yield their benefits to an entity over several periods. For example, prepaid insurance, buildings and various kinds of equipment. The allocation procedure may be recognizing depreciation or other amortization.
Thus, if a payment is made in advance, it will be recorded as an asset (pre-paid expense) and expensed in the appropriate period. If services are rendered but not paid, the expense must be accrued, resulting in a liability.
Therefore, the accounting policy at Simple University is inappropriate. Items to be sold should be placed in an asset account (inventory) when purchased. Then, when sold, sales would be recognized and a cost of goods sold expense recorded. If equipment is purchased, it should be capitalized and depreciated according to its useful life.