Revenue recognition
The revenue recognition principle is a cornerstone of accrual accounting together with the matching principle. They both determine the accounting period in which revenues and expenses are recognized. According to the principle, revenues are recognized when they are realized or realizable, and are earned, no matter when cash is received. In cash accounting – in contrast – revenues are recognized when cash is received no matter when goods or services are sold.
Cash can be received in an earlier or later period than obligations are met and related revenues are recognized that results in the following two types of accounts:
- Accrued revenue: Revenue is recognized before cash is received.
- Deferred revenue: Revenue is recognized when cash is received.
International Financial Reporting Standards criteria
TheIFRS provides five criteria for identifying the critical event for recognizing revenue on the sale of goods:
- Risks and rewards have been transferred from the seller to the buyer.
- The seller has no control over the goods sold.
- Collection of payment is reasonably assured.
- The amount of revenue can be reasonably measured.
- Costs of earning the revenue can be reasonably measured.
The third criterion is referred to as Collectability. The seller must have a reasonable expectation of being paid. An allowance account must be created if the seller is not fully assured to receive the payment. The fourth and fifth criteria are referred to as Measurability. Due to Matching Principle, the seller must be able to match expenses to the revenues they helped in earning. Therefore, the amount of Revenues and Expenses should both be reasonably measurable
General rule
Received advances are not recognized as revenues, but as liabilities, until the conditions and are met.- Revenues are realized when cash or claims to cash are received. Revenues are realizable when they are readily convertible to cash or claim to cash.
- Revenues are earned when such goods/services are transferred/rendered.
- Revenues from selling inventory are recognized at the date of sale often interpreted as the date of delivery.
- Revenues from rendering services are recognized when services are completed and billed.
- Revenue from permission to use company's assets is recognized as time passes or as assets are used.
- Revenue from selling an asset other than inventory is recognized at the point of sale, when it takes place.
Revenue versus cash timing
Deferred revenue is a liability, such as cash received from a counterpart for goods or services which are to be delivered in a later accounting period. When the delivery takes place, income is earned, the related revenue item is recognized, and the deferred revenue is reduced.
For example, a company receives an annual software license fee paid out by a customer upfront on January 1. However the company's fiscal year ends on May 31. So, the company using accrual accounting adds only five months worth of the fee to its revenues in profit and loss for the fiscal year the fee was received. The rest is added to deferred income on the balance sheet for that year.
Advances
are not considered to be a sufficient evidence of sale; thus, no revenue is recorded until the sale is completed. Advances are considered a deferred income and are recorded as liabilities until the whole price is paid and the delivery made.Exceptions
Revenues not recognized at sale
The rule says that revenue from selling inventory is recognized at the point of sale, but there are several exceptions.- Buyback agreements: buyback agreement means that a company sells a product and agrees to buy it back after some time. If buyback price covers all costs of the inventory plus related holding costs, the inventory remains on the seller's books. In plain: there was no sale.
- Returns: companies which cannot reasonably estimate the amount of future returns and/or have extremely high rates of returns should recognize revenues only when the right to return expires. Those companies that can estimate the number of future returns and have a relatively small return rate can recognize revenues at the point of sale, but must deduct estimated future returns.
Revenues recognized before sale
Long-term contracts
This exception primarily deals with long-term contracts such as constructions, development of aircraft, weapons, and space exploration hardware. Such contracts must allow the builder to bill the purchaser at various parts of the project.- The percentage-of-completion method says that if the contract clearly specifies the price and payment options with transfer of ownership, the buyer is expected to pay the whole amount and the seller is expected to complete the project, then revenues, costs, and gross profit can be recognized each period based upon the progress of construction. For example, if during the year, 25% of the building was completed, the builder can recognize 25% of the expected total profit on the contract. This method is preferred. However, expected loss should be recognized fully and immediately due to conservatism constraint. Apart from accounting requirement, there is a need for calculating the percentage of completion for comparing budgets and actuals to control the cost of long-term projects and optimize Material, Man, Machine, Money and time . The method used for determining revenue of a long-term contract can be complex. Usually two methods are employed to calculate the percentage of completion: by calculating the percentage of accumulated cost incurred to the total budgeted cost. by determining the percentage of deliverable completed as a percentage of total deliverable. The second method is accurate but cumbersome. To achieve this, one needs the help of a software ERP package which integrates Financial, inventory, Human resources and WBS based planning and scheduling while booking of all cost components should be done with reference to one of the WBS elements. There are very few contracting ERP software packages which have the complete integrated module to do this.
- The completed-contract method should be used only if percentage-of-completion is not applicable or the contract involves extremely high risks. Under this method, revenues, costs, and gross profit are recognized only after the project is fully completed. Thus, if a company is working only on one project, its income statement will show $0 revenues and $0 construction-related costs until the final year. However, expected loss should be recognized fully and immediately due to conservatism constraint.
Completion of production basis
Revenues recognized after Sale
Sometimes, the collection of receivables involves a high level of risk. If there is a high degree of uncertainty regarding collectibility then a company must defer the recognition of revenue. There are three methods which deal with this situation:- Installment sales method allows recognizing income after the sale is made, and proportionately to the product of gross profit percentage and cash collected calculated. The unearned income is deferred and then recognized to income when cash is collected. For example, if a company collected 45% of total product price, it can recognize 45% of total profit on that product.
- Cost recovery method is used when there is an extremely high probability of uncollectable payments. Under this method no profit is recognized until cash collections exceed the seller's cost of the merchandise sold. For example, if a company sold a machine worth $10,000 for $15,000, it can start recording profit only when the buyer pays more than $10,000. In other words, for each dollar collected greater than $10,000 goes towards your anticipated gross profit of $5,000.
- Deposit method is used when the company receives cash before sufficient transfer of ownership occurs. Revenue is not recognized because the risks and rewards of ownership have not transferred to the buyer.
- Generally accepted accounting principles
- Comparison of cash and accrual methods of accounting
- Vendor-specific objective evidence
New Revenue Recognition Standard
The new standard aims to:
- Remove inconsistencies and weaknesses in revenue requirements
- Provide a more robust framework for addressing revenue issues
- Improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets
- Provide more useful information to users of financial statements through improved disclosure requirements
- Simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer