Timing plays a pivotal role in financial reporting. Under accrual-basis accounting, the end of the accounting period acts as a “cutoff” for recognizing revenue and expenses. However, some companies may be tempted to manipulate timing–especially at the end of the year–to boost financial results or reduce taxes.
Understanding end-of-period cutoffs
According to U.S. Generally Accepted Accounting Principles (GAAP), revenue should be recognized in the period it’s earned, regardless of when the cash is received. Expenses also must be recorded in the period they are incurred, not just when they’re paid.
Since it’s essential to properly match expenses to the revenue they generate, businesses should document expenses in the same period they were incurred to align with the corresponding revenue.
Some companies might stretch the cutoff rules to present their financial results in a more favorable light. For instance, consider a car dealer letting a customer take a vehicle home on December 28, 2024, for a test drive. The customer has verbally agreed to the deal but hasn’t finalized it yet, intending to return on January 2 to either finalize the purchase or return the vehicle.
Should this sale be recorded in 2024 or 2025 under accrual accounting?
Now think about a retailer that pays January’s rent on December 31, 2024. Under accrual-based accounting, can they deduct that extra month’s rent from this year’s taxable income?
While the temptation to inflate revenue to impress stakeholders or defer taxable income to reduce your current tax burden is real, the cutoff for a calendar-year, accrual-basis business is December 31. In both scenarios, the transactions should be reported in 2025.
Cutoff compliance checks
Auditors use various procedures to ensure compliance with cutoff rules. To confirm revenue is recorded accurately, they may review:
- Shipping documents and customer invoices
- Sales transactions occurring close to the cutoff date
- Returns and allowances recorded near the cutoff date.
To ensure that expenses are recorded in the appropriate accounting period, auditors review contracts and invoices from near the cutoff date. They also ensure that expenses are properly matched with the revenue they support, according to the matching principle.
This means that expenses incurred during the current period but not yet paid are recorded as accruals or liabilities. In contrast, prepaid assets are costs paid in advance, to be recognized in future periods as they help drive revenue. Auditors often use analytical techniques to track expense trends as a percentage of sales from one period to the next, helping to identify timing discrepancies and unusual patterns.
Keep in mind that new revenue reporting standards went into effect in 2018 for public companies and in 201 for private businesses. According to Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, revenue should be recognized in a way that represents the transfer of promised goods or services to customers, in an amount that reflects the expected payment for those goods or services.
Though this guidance has been in place for several years, many smaller private companies still face challenges with its implementation. The rules require management to make judgment calls each reporting period, including identifying contractual performance obligations, allocating transaction prices to these obligations, and estimating any variable consideration.
The potential for misstatements and the need for thorough disclosures have led auditors to closely scrutinize how companies recognize revenue, especially from long-term contracts. During audit fieldwork, you can anticipate detailed questions about your company’s cutoff policies and rigorous testing to ensure compliance with these accounting rules.
Questions about cutoffs?
As the end of the year approaches, questions about the cutoff rules for reporting revenue and expenses are bound to arise. Get in touch with your Smolin advisor for guidance. We’ll help you stay compliant and minimize any last-minute audit adjustments.