Let’s start with the matching principle. This means simply to match the timing of the revenue with the timing of the expense. For example, in the case of a marketing firm one could argue that their big win, their hard work, their blood, sweat and tears is in winning a marketing contract and making sales. In this example, let’s recognize right now that the hard work was done and the battle was won the moment that this sale was made and the contract was signed.
Even if the buyer will string out his payments throughout multiple months or years- may not matter- the hard work or in accounting terms “the earnings process” is already “substantially complete” at the point of sale, in this simple example.
Secondly, the accrual method of accounting for certain transactions may allow the earnings to be recognized right now, even if the accompanying cash flows are still months or years away.
Accountants will draw a distinction between an account receivable (a contractual cash flow) and expected future cash flows, wherein underlying agreement may not be fully contractual.
Example, John built a product, by investing his life savings of $2 million to build a small rocket. Assume John’s balance sheet is currently showing shareholder’s equity of $2 million as well. Now, the business sells the rocket for $8 million. The buyer entered into a payment plan (contractual cash flow) to pay $1 million, per year over the next 8 years.
Obviously, there is a $6 million gain in this very simplistic example. But there are two very different accounting methods that could possibly be applied. The cash method of accounting may recognize this $6million gain, over the next 8 years. The accrual method of accounting may recognize the entire $6 million gain, right now. One can quickly grasp the explosive difference in financial statements.
Finally, we are not accountants here. Obviously, do not rely on us for accounting advice. Consult your own accountant and auditors. There are multiple criteria to qualify for accrual accounting and revenue recognition would be far more involved than our simplistic example above. We just like to explore options.
