Revenue recognition

The revenue recognition principle is a cornerstone of accrual accounting together with 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 (usually when goods are transferred or services rendered), 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 (when goods or services are delivered) and related revenues are recognized that results in the following two types of accounts:

IFRS Criteria To Recognize Revenue

The Critical-Event Approach: IFRS provides five criteria for identifying the critical event for recognizing revenue on the sale of goods

  1. Risks and rewards have been transferred from the seller to the buyer
  2. The seller has no control over the goods sold
  3. Collection of payment is reasonably assured
  4. The amount of revenue can be reasonably measured
  5. Costs of earning the revenue can be reasonably measured

The first two criteria mentioned above are referred to as Performance. Performance occurs when the seller has done most or all of what it is supposed to do to be entitled for the payment. E.g.: A company has sold the good and the customer walks out of the store with no warranty on the product. The seller has completed its performance since the buyer now owns good and also all the risks and rewards associated with it. 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 (deferred income), until the conditions (1.) and (2.) are met.

  1. Revenues are realized when cash or claims to cash (receivable) are received in exchange for goods or services. Revenues are realizable when assets received in such exchange are readily convertible to cash or claim to cash.
  2. Revenues are earned when such goods/services are transferred/rendered. Both such payment assurance and final delivery completion (with a provision for returns, warranty claims, etc.), are required for revenue recognition.

Recognition of revenue from four types of transactions:

  1. Revenues from selling inventory are recognized at the date of sale often interpreted as the date of delivery.
  2. Revenues from rendering services are recognized when services are completed and billed.
  3. Revenue from permission to use company's assets (e.g. interests for using money, rent for using fixed assets, and royalties for using intangible assets) is recognized as time passes or as assets are used.
  4. Revenue from selling an asset other than inventory is recognized at the point of sale, when it takes place.

Revenue vs. cash timing

Accrued revenue (or accrued assets) is an asset such as proceeds from a delivery of goods or services, at which such income item is earned and the related revenue item is recognized, while cash for them is to be received in a latter accounting period, when its amount is deducted from accrued revenues. It shares characteristics with deferred expense (or prepaid expense, or prepayment) with the difference that an asset to be covered later is cash paid out to a counterpart for goods or services to be received in a latter period when the obligation to pay is actually incurred, the related expense item is recognized, and the same amount is deducted from prepayments

Deferred revenue (or deferred income) 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 such income item is earned, the related revenue item is recognized, and the deferred revenue is reduced. It shares characteristics with accrued expense with the difference that a liability to be covered later is an obligation to pay for goods or services received solo from a counterpart, while cash for them is to be paid out in a later period when its amount is deducted from accrued expenses.

For example, a company receives an annual software license fee paid out by a customer upfront on the January 1. However the company's fiscal year ends on May 31. So, the company using accrual accounting adds only five months worth (5/12) 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 (liability) on the balance sheet for that year.

Advances

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 (i.e. matching obligations are incurred).

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.

Revenues recognized before sale

Long-term contracts

This exception primarily deals with long-term contracts such as constructions (buildings, stadiums, bridges, highways, etc.), development of aircraft, weapons, and space exploration hardware. Such contracts must allow the builder (seller) to bill the purchaser at various parts of the project (e.g. every 10 miles of road built).

Completion of production basis

This method allows recognizing revenues even if no sale was made. This applies to agricultural products and minerals.There is a ready market for these products with reasonably assured prices, the units are interchangeable, and selling and distributing does not involve significant costs.

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:


References

  1. ↑ Revsine 2002, p. 110
  2. ↑ Financial Accounting Standards Board (2008). "Statement of Financial Accounting Standards No. 66, Paragraph 65". Retrieved March 23, 2009.

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