Is Your Company Following the Accounting Rules for Cutoffs?
Under the accrual method of accounting, the end of the accounting period serves as a strict cutoff for recognizing revenue and expenses. However, during economic downturns, managers may be tempted to artificially inflate earnings or reduce losses. As a result, they may extend revenue cutoffs beyond the end of the period or delay reporting expenses until the next period. Here’s an overview of the rules for recognizing revenue and expenses under U.S. Generally Accepted Accounting Principles (GAAP), along with insight into what cutoff testing procedures you can expect during audit fieldwork.
Under accrual-based accounting methods, revenue and expenses are matched in the reporting periods that they’re earned and incurred. The exchange of cash doesn’t necessarily drive the recognition of revenue and expenses under GAAP. The rules may be less clear for certain services and contract sales, tempting some companies to play timing games to artificially boost financial results.
Companies that follow GAAP recognize revenue when the earnings process is complete, and the rights of ownership have passed from seller to buyer. Rights of ownership include possession of an unrestricted right to use the property, title, assumption of liabilities, transferability of ownership, insurance coverage and risk of loss.
Gaming Year-End Cutoffs
Some companies apply liberal interpretations of the cutoff rules to either:
- Minimize taxable income for the period, or
- Overstate revenue and/or understate expenses to artificially enhance profits for the accounting period.
The difference is a matter of timing because the effects will be reversed in the next accounting period. But these manipulations violate GAAP.
To illustrate, let’s suppose a calendar-year, accrual-basis car dealer allowed a customer to take home a vehicle for a weekend test drive on December 30, 2022. The sales manager had verbally negotiated a deal with the customer, but the customer wanted to crunch the numbers with his spouse before signing the contract. The customer planned to return on January 3, 2023, to close the deal — or return the vehicle. Should the sale be reported in 2022 or 2023?
Alternatively, consider a calendar-year, accrual-basis retailer that paid rent for January 2023 on December 30, 2022. Rent is due on the first day of the month. Can the store deduct the extra month’s rent from taxable income for 2022?
As tempting as it might be to inflate revenue to impress stakeholders or defer profits to lower your tax bill, the cutoff for a calendar-year, accrual-basis business is December 31. So in both examples, the transactions should be reported in 2023 under GAAP.
Important: Some small businesses may not follow GAAP. If a company uses the cash-basis accounting method and pays January 2023 rent before the end of 2022, the payment may be reported as an expense in the year it was paid (2022). But revenue from a sale that’s not yet complete (as in the first example) wouldn’t be recognized until 2023 under either the cash or accrual methods.
Accounting for Long-term Contracts
The rules regarding cutoffs recently changed for companies that enter into long-term contracts. Under Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, revenue should be recognized “to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for the goods or services.”
The updated guidance was published in 2014, and it went into effect in 2018 for public companies. During the pandemic, the Financial Accounting Standards Board (FASB) deferred the effective dates for all nonpublic entities that hadn’t yet issued their financial statements to annual reporting periods beginning after December 15, 2019, and interim reporting periods within annual reporting periods beginning after December 15, 2020.
The principles-based guidance requires companies to follow five steps when deciding how and when to recognize revenues:
- Identify a contract with a customer,
- Separate the contract’s commitments,
- Determine the transaction price,
- Allocate a price to each promise, and
- Recognize revenue when or as the company transfers the promised good or service to the customer, depending on the type of contract.
Disclosure requirements were also expanded by the updated guidance. Companies must now provide detailed footnotes that break down revenue by product lines, geographic markets, contract length, services and physical goods.
There are industry-specific exceptions to the updated guidance. For example, certain transactions related to insurance contracts, leases, financial instruments, guarantees and nonmonetary exchanges between entities in the same line of business to facilitate sales, remain within the scope of existing industry-specific GAAP.
Auditors closely monitor revenue and expense cutoff procedures for all businesses. For example, it’s customary for auditors to review sales contracts and invoices from the last month of the year and the first month of the next year, checks held at year end, and collections and returns made in the first month of the next year.
However, the updated guidance on recognizing revenue from long-term contracts has required auditors to step up their game. The guidance requires management to make judgment calls about identifying performance obligations (promises) in contracts, allocating transaction prices to these promises and estimating variable consideration. These judgments could be susceptible to management bias or manipulation. If your company is affected by the updated guidance, auditors may inquire about cutoff policies and perform additional cutoff testing procedures to evaluate whether or not your reporting practices comply with GAAP.
For More Information
Accounting cutoffs can be confusing in certain situations. Plus, for companies with long-term contracts, the rules for recognizing and disclosing revenue have changed in recent years. Contact Kirsch CPA Group with any questions you have about the cutoff rules or if you suspect that management may be pushing the limits to artificially boost earnings. An outside professional can help you navigate the rules and investigate any concerns you may have.
© Copyright 2023. All rights reserved.