U.S. Generally Accepted Accounting Principles (GAAP) require companies to follow the accrual method of accounting. A critical component of this method is end-of-period “cutoffs” for recognizing revenue and expenses. Is your company properly applying the cutoff rules? As year-end approaches, it’s important to review your policies and procedures to ensure accurate financial reporting.
Matching principle
The exchange of cash doesn’t drive the recognition of revenue and expenses under GAAP. Accrual accounting requires revenue and expenses to be matched in the reporting periods in which they’re earned and incurred.
Companies that follow GAAP recognize revenue when the transfer of control has passed from seller to buyer. Some indicators that control has transferred include possession of an unrestricted right to use the property, title, assumption of liabilities, transferability of ownership, insurance coverage and risk of loss.
The rules may be less clear for certain services and contract sales, tempting some companies to play timing games to artificially boost financial results. As a result, external auditors pay close attention to compliance with the cutoff rules, especially when it comes to long-term contracts. (See sidebar below.)
Long-term contracts
Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, provides guidance on applying the cutoff rules when reporting revenue from long-term contracts. It explains that 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.”
Further, the guidance requires companies to follow five steps when deciding how and when to recognize revenue:
1. Identify a contract with a customer,
2. Separate the contract’s commitments,
3. Determine the transaction price,
4. Allocate a price to each promise, and
5. Recognize revenue when or as the company transfers the promised good or service to the customer, depending on the type of contract.
In addition, companies must provide detailed footnote disclosures that break down revenue by product lines, geographic markets, contract length, services and physical goods.
However, there are several general and industry-specific exceptions to ASU 2014-09. Examples of transactions that aren’t within the scope of this guidance are nonreciprocal contributions to nonprofits, insurance contracts, leases, financial instruments, guarantees, nonmonetary exchanges between entities in the same line of business to facilitate sales, certain collaborative arrangements and some government contracts.
Cutoff manipulations
Managers may be tempted to interpret the cutoff rules loosely under certain conditions. For instance, they might artificially inflate earnings or reduce losses to hide fraud schemes or mask financial distress from economic downturns or weak financial performance. To do so, they may extend revenue cutoffs beyond the end of the period or delay reporting expenses until the next period. Some companies may also apply liberal interpretations of the cutoff rules to minimize taxable income for the 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 software company negotiates a deal on December 27, 2025, to sell a large one-year subscription for its platform. The salesperson, eager to meet year-end revenue targets, reports the sale immediately. However, the customer doesn’t sign the contract until January 2, 2026, and the subscription services will begin that same month. Should this contract be reported as revenue in 2025 or 2026?
Under GAAP, the year-end cutoff for this hypothetical software company is December 31. So, it wouldn’t be allowed to recognize the revenue from this transaction in 2025 because the contract was signed in 2026. Instead, the sale must be recognized ratably as revenue over the 12-month subscription term in 2026. Recording the revenue early would artificially inflate 2025 results and understate 2026 performance.
Important: Some small businesses don’t follow GAAP. If a company uses the cash-basis accounting method, revenue and expenses are typically recognized when cash changes hands, not when earned or incurred, as defined under GAAP.
For more information
Accounting cutoffs can be confusing in certain situations. Contact your Hood & Strong team for answers to questions about the cutoff rules or if you suspect that management may be pushing the limits to artificially boost earnings. Our professionals can help you comply with the rules and investigate any concerns you may have.
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Sidebar: What Cutoff Testing Procedures Can You Expect During Audit Fieldwork?
Auditors closely evaluate revenue and expense cutoff procedures for all businesses. For example, to confirm recognition in the correct accounting period, it’s customary for auditors to review:
· Sales contracts and invoices,
· Shipping and receiving documents (such as bills of lading and receiving reports),
· Checks held at year end,
· Cash disbursements, and
· Collections and returns.
When recognizing revenue from long-term contracts, a company’s management must 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. During fieldwork, auditors may inquire about cutoff policies and perform additional cutoff testing procedures to evaluate whether your reporting practices comply with U.S. GAAP.
