Revenue Recognition

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The revenue recognition principle is a foundation of accrual accounting and one of the main principles of GAAP. The revenue recognition principle is a set of guidelines that helps accountants to identify when a revenue event has taken place and how to appropriately record cash exchanges before, during, and after the revenue event. According to the revenue recognition principal, revenue must (1) be realized or realizable and (2) earned, in order to be recognized. According to the SEC revenue is realized when (1) Persuasive evidence of an arrangement exists, (2) Delivery has occurred or services have been rendered, (3) The seller’s price to the buyer is fixed or determinable, and (4) Collectability is reasonably assured. It is essential for the users of financial statements to know that the real revenues are recorded and disclosed and not fraudulent revenues. A constraint of GAAP that is relevant to the revenue recognition principle is the materiality principle. Fraudulent revenues will create misstatements that could have a material effect on the decisions of financial statement users. In 2002, WorldCom a telecommunication company, filed for bankruptcy. It was later revealed that the company was involved with improper accounting in two major forms. First WorldCom inflated revenues to increase profits, thereby increasing stock prices, and increasing the satisfaction of stakeholders. Second, the company understated line costs. Revenue is important to users of financial statements because it helps them evaluate a company’s performance and prospects. WorldCom violated the revenue recognition principle by creating an account that did not come from the operating activities of the company’s sales channel. WorldCom named this fictitious schedule corporate unallocated account. This action was unethical and illegal, and gave the company a very bad reputation.

According to paragraph 25 of PCAOB Auditing Standard No. 5, because of its importance to effective internal...
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