Revenue Recognition Principle
The Revenue Recognition Principle is an important accounting principle that determines when revenue should be recorded and reported in the financial statements. According to this principle, revenue is considered earned and is recognised when it is realised or realisable, irrespective of the actual date on which cash is received.
Therefore, the receipt of cash is not the primary factor for recognising revenue under this principle. The important consideration is whether the revenue has been earned and whether the conditions for recognising the revenue have been satisfied.
The revenue recognition principle is a cornerstone of accrual accounting. It operates together with the Matching Principle. The revenue recognition principle and matching principle collectively determine the accounting period in which revenues and related expenses should be recognised.
Under accrual accounting, revenue may be recognised even when cash has not yet been received. Similarly, cash received in advance does not necessarily represent revenue because the related goods or services may not yet have been provided.
Revenue Recognition under Cash Accounting
The treatment of revenue under cash accounting is different from accrual accounting. Under the cash accounting method, revenue is recognised when cash is actually received, regardless of when the goods are sold or services are provided.
Thus, under cash accounting, the timing of cash receipt determines revenue recognition. Under accrual accounting, the earning of revenue determines its recognition.
Cash may be received either before or after the business fulfils its obligations. This difference in timing gives rise to accrued revenue and deferred revenue.
Accrued revenue arises when revenue is recognised before cash is received. In contrast, deferred revenue arises when cash is received before the related revenue is recognised.
Rules of Revenue Recognition
When a company receives an advance payment from a customer, the amount is not immediately recognised as revenue. Instead, the advance is initially recorded as a liability in the form of deferred income or deferred revenue.
It is treated as a liability because the company has an obligation to provide goods or services in the future. The company has received cash but has not yet completely performed its obligation towards the customer.
Revenue is recognised when the necessary revenue recognition conditions are satisfied. The cash or accounts receivable should be received or the advances should be readily convertible into cash or receivables. In addition, the related goods must be transferred or services must be rendered.
Therefore, the receipt of cash alone does not automatically result in revenue recognition. The company must also perform the required obligation relating to the goods or services.
Recognition of Revenue from Different Activities
Revenue from the sale of inventory is normally recognised on the date of sale. In many cases, the date of sale is the date on which the goods are delivered to the customer.
Revenue from providing services is generally recognised when the services have been completed and billed. The completion of the service represents the performance of the required obligation.
Revenue arising from permission to use a company’s assets is recognised as time passes or as the assets are used. Thus, revenue recognition depends on the period of use or actual use of the asset.
Revenue from the sale of an asset other than inventory is recognised at the point of sale when the sale actually takes place.
Accrued Revenue
Accrued revenue is an asset representing income that has already been earned through the delivery of goods or services, although payment has not yet been received.
The business has fulfilled its obligation and therefore has earned the income. However, the customer has not yet made the payment. Since the business has a right to receive the amount, accrued revenue is treated as an asset.
When payment is eventually received, the accrued revenue account is adjusted or removed, and the cash account is increased.
For example, if a business provides a service during the current accounting period but receives payment in a later period, the revenue is recognised in the current period as accrued revenue.
Deferred Revenue
Deferred revenue is a liability representing the future obligation of a business to provide goods or services even though payment has already been received in advance.
The receipt of cash creates an obligation because the company must deliver the promised goods or services in the future. Therefore, the amount cannot immediately be treated as earned revenue.
When the goods or services are finally delivered, the deferred revenue account is adjusted or removed and the income is recognised as revenue.
Thus, accrued revenue represents revenue earned but cash not yet received, whereas deferred revenue represents cash received but revenue not yet earned.
IFRS Criteria for Revenue Recognition
The International Financial Reporting Standards (IFRS) provide criteria for identifying the critical event at which revenue from the sale of goods should be recognised.
The criteria are based on performance, collectability, and measurability.
Performance Criteria
The performance condition is satisfied when the risks and rewards relating to the goods have been transferred from the seller to the buyer.
In addition, the seller should no longer have control over the goods sold. Therefore, the transfer of risks, rewards, and control is important in determining whether the seller has completed the required performance.
Collectability Criteria
The collection of payment should be reasonably assured. This means there should be a reasonable expectation that the seller will collect the consideration relating to the transaction.
If collection is highly uncertain, revenue recognition may need to be deferred.
Measurability Criteria
The amount of revenue should be capable of being reasonably measured. The business should be able to determine the amount of revenue arising from the transaction.
The costs incurred or expected to be incurred in earning the revenue should also be reasonably measurable. Therefore, both revenue and the related costs should be capable of reasonable measurement.
Revenue Recognition under ASC 606 and IFRS 15
In May 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued converged guidance on revenue recognition.
This guidance is known as ASC 606 under U.S. accounting standards and IFRS 15 under International Financial Reporting Standards. The purpose of the guidance is to improve consistency in recognising revenue arising from contracts with customers.
ASC 606 became effective for public companies in 2017 and private companies in 2018.
The guidance introduced a five-step model for revenue recognition.
Step 1: Identify the Contract
The first step is to identify a valid contract with the customer. A contract is considered valid when the parties are committed to the arrangement, the rights of the parties are clearly identified, the payment terms are clear, and the contract has commercial substance.
Step 2: Identify the Performance Obligations
The company must identify the goods or services promised in the contract. These promised goods or services represent the performance obligations that the company is required to fulfil.
Step 3: Determine the Transaction Price
The transaction price is the amount that the company expects to receive in exchange for the promised goods or services.
The company determines the amount of consideration expected from the customer under the contract.
Step 4: Allocate the Transaction Price
The transaction price is allocated among the identified performance obligations. The allocation is based on the standalone selling price of each performance obligation.
Therefore, where a contract includes multiple goods or services, the total transaction price is divided among the separate performance obligations.
Step 5: Recognise Revenue
Revenue is recognised when control of the promised goods or services is transferred to the customer.
The five-step model applies to a wide range of industries and promotes greater uniformity in the manner in which companies recognise and report revenue.
Exceptions to the General Revenue Recognition Rule
The general rule is that revenue from the sale of inventory is recognised at the point of sale. However, certain circumstances require revenue to be recognised before or after the normal point of sale.
Revenues Not Recognised at the Point of Sale
Buyback Agreements
A buyback agreement is an arrangement under which a company sells a product and agrees to purchase the same product back after a specified period.
If the buyback price covers the entire cost of the inventory together with the related holding costs, the inventory continues to remain in the seller’s books.
In substance, such a transaction is not treated as a genuine sale. Therefore, revenue is not recognised merely because the product has temporarily been transferred to another party.
Sales Returns
Companies may allow customers to return products after sale. Revenue recognition depends on whether the company can reasonably estimate future returns.
A company that cannot reasonably estimate the amount of future returns or experiences an extremely high rate of returns should recognise revenue only when the customer’s right to return the goods expires.
However, if a company can reasonably estimate future returns and normally has a relatively low return rate, it may recognise revenue at the point of sale. In such a case, the company must deduct the estimated amount of future returns.
Revenue Recognised Before Sale
Certain situations allow revenue to be recognised before the final sale is completed. These mainly include long-term contracts and the completion of production basis.
Long-Term Contracts
Long-term contracts generally involve projects that require a significant period for completion. Examples include the construction of buildings, stadiums, bridges, and highways, as well as the development of aircraft, weapons, and spaceflight systems.
Such contracts may allow the builder or seller to bill the purchaser at different stages of the project. For example, in a highway construction contract, billing may occur after every specified distance of road is completed.
Percentage-of-Completion Method
Under the Percentage-of-Completion Method, revenue, costs, and gross profit are recognised during each accounting period according to the progress of the project.
This method may be applied when the contract clearly specifies the price and payment conditions and provides for the transfer of ownership. The buyer should be expected to pay the full contractual amount, and the seller should be expected to complete the project.
For example, if 25% of a building is completed during the year, the builder may recognise 25% of the expected total profit from the contract.
The percentage-of-completion method is the preferred method when its conditions are satisfied. However, an expected loss must be recognised fully and immediately due to the conservatism constraint.
Determining the percentage of completion is also useful for comparing budgeted and actual project performance. It assists in controlling the cost of long-term projects and optimising Material, Man, Machine, Money, and Time, referred to as OPTM4.
Two methods are generally used to calculate the percentage of completion. The first method calculates the accumulated cost incurred as a percentage of the total budgeted cost. The second method determines the completed deliverables as a percentage of total deliverables.
The second method may provide more accurate information but can be difficult and complex to apply. An integrated Enterprise Resource Planning (ERP) system may be required to combine financial information, inventory, human resources, and Work Breakdown Structure-based planning and scheduling.
Completed-Contract Method
The Completed-Contract Method should generally be used only when the percentage-of-completion method is not applicable or when the contract involves extremely high risks.
Under this method, revenue, costs, and gross profit are recognised only after the project is fully completed.
For example, if a company is working on only one project, its income statement may report zero construction revenue and zero construction-related costs until the final year of the project.
However, if a loss is expected on the contract, the expected loss must be recognised fully and immediately because of the conservatism constraint.
Completion of Production Basis
The Completion of Production Basis allows revenue to be recognised even when an actual sale has not yet taken place.
This method applies to certain agricultural products and minerals. These products normally have a ready market with reasonably assured prices.
The units of such products are generally interchangeable, and their sale and distribution do not involve significant costs. Because of these characteristics, revenue may be recognised when production is completed even before an actual sale occurs.
Revenue Recognised After Sale
In some transactions, the collection of receivables involves a high level of risk. If there is significant uncertainty regarding the collectability of the amount due, the company must defer revenue recognition.
Three methods may be used in such situations: the Installment Sales Method, Cost Recovery Method, and Deposit Method.
Installment Sales Method
The Installment Sales Method allows income to be recognised after the sale in proportion to the cash collected.
The amount of income recognised is based on the gross profit percentage and the amount of cash collected. Unearned income is deferred and subsequently recognised as income when cash is collected.
For example, if a company collects 45% of the total selling price of a product, it may recognise 45% of the total profit relating to that product.
Cost Recovery Method
The Cost Recovery Method is used when there is an extremely high probability that payments may not be collected.
Under this method, no profit is recognised until the total cash collected exceeds the seller’s cost of the merchandise sold.
For example, suppose a company sells a machine costing $10,000 for $15,000. The company does not recognise profit until the buyer has paid more than $10,000.
After the first $10,000 of cost has been recovered, each additional dollar collected contributes towards the expected gross profit of $5,000.
Deposit Method
The Deposit Method is used when a company receives cash before a sufficient transfer of ownership has occurred.
Revenue is not recognised because the risks and rewards of ownership have not yet been transferred to the buyer. The cash received is therefore treated as a deposit rather than recognised as revenue.
Exam Focus
The Revenue Recognition Principle states that revenue is earned and recognised when it is realised or realisable, irrespective of when cash is received. It is a fundamental principle of accrual accounting and works together with the matching principle.
Accrued revenue is an asset and represents revenue earned before cash is received. Deferred revenue is a liability and represents cash received before revenue is earned.
Under ASC 606 and IFRS 15, revenue recognition follows a five-step model: identify the contract, identify performance obligations, determine the transaction price, allocate the transaction price, and recognise revenue when control transfers to the customer.
Under the Percentage-of-Completion Method, revenue, costs, and gross profit are recognised according to the progress of a long-term project. Under the Completed-Contract Method, these amounts are recognised only when the project is fully completed.
The Installment Sales Method recognises profit in proportion to cash collected, while the Cost Recovery Method does not recognise profit until cash collections exceed the seller’s cost. Under the Deposit Method, revenue is not recognised until sufficient transfer of ownership has occurred.