Generally accepted accounting principles, or GAAP, refer to a set of U.S. accounting standards established by the Financial Accounting Standards Board. Regarding GAAP revenue recognition, this is a set of standardized rules that deal with how and when revenue is recorded in organizational bookkeeping. Revenue must, according to GAAP, meet certain standards before it can be recorded and listed on financial statements, a process known as revenue recognition.
The Financial Accounting Standards Board outlines two specific criteria regarding GAAP revenue recognition. First, before the revenue recognition can occur, revenue must be either realized or realizable. Realized means that cash has been received, whereas realizable means a promise to pay has been received. Next, revenue must be earned, meaning that the organization offered something in return for the revenues, such as a product or service. Both qualifying criteria must be met before an organization can recognize revenues and record them on financial statements as income.
Typically, GAAP revenue recognition rules apply to accrual basis accounting, rather than cash basis accounting. Accrual accounting records transactions as they occur, without regard for when cash is exchanged. For example, when a pharmacy delivers medication to a patient, the pharmacy earns revenue, even if the business must wait for a patient's insurance company to pay. Likewise, the pharmacy incurs expenses for medication supplies, even if the pharmacy has not yet paid the invoice for a medication shipment.
According to GAAP revenue recognition standards, a business cannot record revenues until a transaction takes place and the revenues are officially earned. In other words, the pharmacy in the previous example cannot record revenue from filling a prescription until the patient completes the transaction by picking up the order. If the patient participates in an automatic refill program, for example, the pharmacy cannot record the revenues from future transactions until each prescription is filled and given to the patient.
Although GAAP revenue recognition rules might seem simple, a variety of transactions do not involve a clear point of revenue realization. Franchise fees, retainer contracts, bill and hold orders, and other transactions can easily cloud the point at which an organization is able to recognize the revenues generated. While the GAAP rules are intended to be flexible to fit the needs of a variety of business models, ambiguity has led to misinterpretation regarding the spirit of the rules.
Numerous high-profile cases were reported in the late 1990s, all involving publicly traded companies misapplying GAAP revenue recognition rules to inflate income statements. As such, numerous specialized handling rules have been developed by the Financial Accounting Standards Board in an effort to prevent fraudulent or overinflated income statements. Additionally, the Securities and Exchange Commission, or SEC, helped enact various laws to regulate financial statement accuracy and managerial accountability regarding revenue recognition.