Revenue recognition

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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 realised or realisable, 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:

• Accrued revenue: Revenue is recognized before cash is received.
• Deferred revenue: Revenue is recognized after cash is received.

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.

In practice, this means that revenue is recognized when an invoice has been sent.

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.

• 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 which 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 (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).

• 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 (that is, percentage of completion). 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.
• 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

This method allows recognizing revenues even if no sale was made. This applies to agricultural products and minerals because 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:

• 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.^[1] 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 uncollectble 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.^[2]

See also

• Generally accepted accounting principles
• Comparison of cash and accrual methods of accounting
• Vendor-specific objective evidence

References

Sources

• Revsine, Lawrence (2002), Financial reporting & analysis, Prentice Hall, ISBN 978-0-13-032351-4, http://books.google.com/books?id=WgNFAAAAYAAJ 

External links

• Revenue recognition explained with a simple case study