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Cornerstones of Financial Accounti...

4th Edition
Jay Rich + 1 other
ISBN: 9781337690881

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Cornerstones of Financial Accounti...

4th Edition
Jay Rich + 1 other
ISBN: 9781337690881
Textbook Problem
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Revenue Recognition

Mary Wade owns a small business that rents parking spaces to students at the local university. Mary’s typical rental contract requires the student to pay the year’s rent of $720 ($60 per month) in advance. When Mary prepares financial statements at the end of December, her accountant requires that Mary spread the $720 over the 12 months that a parking space is rented. Therefore, Mary can recognize only $240 revenue (4 months) from each contract in the year the cash is collected and must defer recognition of the remaining $480 (8 months) to next year. Mary argues that getting students to agree to rent the parking space is the most difficult part of the activity so she ought to be able to recognize all $720 as revenue when the cash is received from a student.

Required:

CONCEPTUAL CONNECTION Explain why generally accepted accounting principles require the use of accrual accounting rather than cash-basis accounting for transactions like the one described here.

To determine

Revenue recognition:

Revenue recognition is referred to the time of recognition of revenue by the business firms in the books for stating the respective revenue in the statement of profit and loss in the respective year and time ignoring whether the income is realized in cash or not.

The reason of using accrual accounting over cash accounting under generally accepted accounting principles.

Explanation

In the question, it is given that the Mary Wade owns a business which rents the parking spaces at $720 which the owner receives in advance. The owner earned the income for 4 months only in the current year.

The revenue recognition is considered to be on accrual basis in the generally accepted accounting principles as the financial statements give a correct and fair view of the respective year. The one described in the question provides that the income received in advance but earned only for 4 months. So, if the whole amount is recognized in the year of receipt then the income will be overstated by $480 as it is not earned yet

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