What Is Revenue Recognition Principle?
The revenue recognition principle is a generally accepted accounting principle (GAAP) that outlines the specific conditions under which the revenue is recognized or accounted for. Cash may be received earlier or later after the goods and services have been delivered to the customer and the revenue is recognized.
This principle clearly outlines when and how the revenue earned should be recognized and recorded in the books of accounts. It provides a uniform and useful framework that records the amount collected. Since earning revenue is the main aim of a business and is a benchmark to evaluate its performance, it should be recorded with reasonable certainty and help in improving comparability among companies.
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Revenue Recognition Principle Explained
It is crucial to understand the revenue recognition principle and properly account for it. The accrual principle of revenue recognition in accounting aids in understanding the actual level of economic activity within a business. The deferred principle of accounting results in a correct reporting of assets and liabilities and guards against treating Unearned income refers to any additional earnings made from the sources other than employment, such as returns on investments, dividends on bonds and equities, interest on savings, etc.unearned incomeUnearned IncomeUnearned income refers to any additional earnings made from the sources other than employment, such as returns on investments, dividends on bonds and equities, interest on savings, etc. as an asset. It is crucial to understand the revenue recognition principle in accounting and properly account for the same.
It would primarily result in two types of revenue recognition principles: the Accrued revenue and the Deferred revenue accountsRevenue AccountsRevenue accounts are those that report the business's income and thus have credit balances. Revenue from sales, revenue from rental income, revenue from interest income, are it's common examples..
#1 – Accrued Principle of Revenue Recognition
source: Colgate SEC Filings
Under accrual accountingAccrual AccountingAccrual Accounting is an accounting method that instantly records revenues & expenditures after a transaction occurs, irrespective of when the payment is received or made. , revenues need to be recorded in the same accounting period it has been earned, irrespective of the timings of the related cash flows from that transaction.
Suppose the seller is doubtful about receiving the amount from the customer. In that case, he will recognize an allowance for doubtful accountsAllowance For Doubtful AccountsAllowance for doubtful accounts primarily means creating an allowance for the estimated part that may be uncollectible and may become bad debt and is shown as a contra asset account that reduces the gross receivables on the balance sheet to reflect the net amount expected to be paid. in the amount by which the customer will likely default on the payment.
#2 – Deferred Principle of Revenue Recognition
source: Salesforce SEC Filings
Deferred revenueDeferred RevenueDeferred Revenue, also known as Unearned Income, is the advance payment that a Company receives for goods or services that are to be provided in the future. The examples include subscription services & advance premium received by the Insurance Companies for prepaid Insurance policies etc. refers to the payments received in advance for the services yet not rendered or goods yet not delivered. The deferred revenue classifies as an asset once the company delivers the services or goods to the customer. If a company receives advance payment, it classifies it as a liability, as the service is not yet performed and needs to be delivered in the future.
Salesforce.com reported its deferred income under the current liability section. It is $7,094,705 in FY2018 and $5,542,802 in FY2017.
The five essential criteria for identifying the phenomenon about revenue recognition on the sale of goods as provided by IFRSIFRSIFRS or International Financial Reporting Standards refers to a globally-accepted set of accounting and financial reporting guidelines for preparing and presenting financial statements. It ensures uniformity in accounting practice that makes financial records comparable across different reporting entities worldwide. Over the years, it has emerged as the new world standard in accounting. is as follows-
- Risks and rewards have been transferred from the seller to the buyer.
- The seller does not have any control over the goods sold.
- The collection of payment from the goods and services is reasonably assured.
- The amount of revenue can be reasonably measured.
- Costs of earning the revenue can be reasonably measured.
#1 – Performance
Conditions (1) and (2) refer to performance. It occurs when the seller has completed the transaction as required for him to be given the payment.
#2 – Collectability
Condition (3) refers to Collectability. The seller must have a reasonable expectation that he will be paid for the performance. An allowance account must be maintained if the seller is not fully assured of receiving the payment.
#3 – Measurability
Conditions (4) and (5) refer to Measurability. The seller must match the revenues to the expenses as per the matching principle concept.
Let us understand the concept of revenue recognition principle in accounting with the help of some suitable examples, as given below:
A cleaning company named XYZ Ltd. has committed to providing services to a customer. The company accepted the prepaymentPrepaymentPrepayment refers to paying off an expense or debt obligation before the due date. Often, companies make advance payments for expenses as well as goods and services to shed their financial burden. Advance payments also act as a tool to attain monetary benefits. Examples of prepayment include loan repayment before the due date, prepaid bills, rent, salary, insurance premium, credit card bill, income tax, sales tax, line of credit, etc. of its monthly fee of Rs.300 in advance for a full year. This advance fee is considered as deferred revenue expenditure and should be treated as a liability since the service is yet to be performed by the cleaning company. The advance fee received, which is effectively unearned, is converted to an asset only after the cleaning company performs the monthly service as promised to the customer.
Other examples are advance rent payments, annual prepayment for software use, prepaid insurancePrepaid InsurancePrepaid Insurance is the unexpired amount of insurance premium paid by the company in an accounting period. This portion of unexpired insurance is an asset and will be shown in the balance sheet of the company., advance payment for newspaper subscriptions, etc.
LMN Ltd. bills Rs.100 per hour for the service rendered. In January 2017, it performed 6000 hours of consulting, thus generating revenue of Rs.6,00,000. The company decided to invoice the clients in February 2017.
The company will have to record Rs.6,00,000 as accrued revenue on the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. of January 2017 and Rs.6,00,000 in revenue in the January income statement. Thus, it recorded that the company earned revenue in January though it has not received the payment for the same.
The company will convert Rs.6,00,000 of accrued revenue to accounts receivable once the invoice is sent. The accounts receivable willAccounts Receivable WillAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. , in turn, be converted to cash when the payment is received from the respective customer.
The methods for revenue recognition in an income statement have been explained.
1) – Completed Contract Method
Under this method, the revenue associated with a transaction is recognized only after completing the transaction. This method is generally used in case of uncertainty concerning the collection of funds from the client.
2) – Installment Method
The seller accounts for the transaction by using the installment method when the customer is allowed to pay for the product/service over several years.
3) – Cost Recovery Method
As per the cost recovery methodCost Recovery MethodThe Cost Recovery Method is one of the revenue recognition methods in which the company does not record gross profit or income generated against goods sold to customers until the total cost element related to the respective sale has been fully received by the company from the customer. After the total cost amount has been received, the remaining amount is recorded as income., the revenue recognition is only done after the cost factor of the sale has been paid by the customer in cash.
4) – Percentage of Completion Method
The seller can recognize some gain or loss related to the deal in every accounting periodAccounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance. in which the deal continues to be in force. This method is usually adopted while handling long-term projects.
Following the revenue recognition principle in GAAP and IFRS strictly is very crucial in order to present a true and fair view of the financial statements so that stakeholders can identify the financial health of the business properly and make investment decisions that affects the future expansion and growth of the company.
The revenue recognition principle in GAAP and IFRS followed in the modern industrial era is very updated and transparent in nature. It helps to easily compare the financial statements of peer companies by following a few standardized steps as given below. Let us try to understand the same.
It is necessary to identify and agree to the terms and conditions of contact related to transfer of goods and services. Both the vendor and the client must agree to the terms specified in the contract regarding delivery and payment collection of the same and abide by the rules and face legal consequences in case the consequences are not met. The contracts are typically a written document by may sometimes be verbally specified, depending on the relationship between the client and vendor.
This step involves identifying the products or services that are transacted. Every agreement will revolve round some specific product or service that the parties will deal with in the process.
Next, it is necessary to identify the prices at which the goods will be sold. These prices in the core revenue recognition principle are not only the price of product but will also include any discount, sales promotion incentives, sales return policies, any extra fees, penalty for delay in payment, etc. Such prices are fixed after analysis of many external and internal factors like current market price of competitors, production cost, product demand, customer base, future expansion plans, etc.
In this step, the selling price is clearly allocated to different parts of the contractual obligation so as to bring about a clarity in the price levels of the entire product or service.
Finally the required revenue is recognized when the transaction is complete and the amount for payment is realized by the seller. Both the parties are satisfied with meeting the transaction obligations. The fund received in recorded in the books of accounts following the accounting rules for transparency, accountability and information for stakeholders.
Thus, the above are the steps followed in the core revenue recognition principle so that every business can record details of every transaction properly and refer to them for future purposes.
Revenue Recognition Principal Vs Revenue Recognition Agent
The above are two different concepts followed in the revenue accounting process. However, there are some differences between them as follows.
- The former deals with the different criterias and guidelines a business follows to recognize the revenue earned in the financial statements, whereas the latter deals with how an entity acts as a agent to facilitate a transaction of purchase and sale.
- In the former, both the buyer and seller has complete control over the products and services bought and sold. But in case of the latter, the agent does not have any control over the goods.
- In case of the former, the buyer or seller are the main parties and in case of the latter, the agent is just an intermediary.
- For the former, the entire amount transacted in recorded in the financial statements but in case of the latter, the value recorded in the books has been after deduction of the commission charged by the agent.
Therefore, it is important to understand whether a company is acting as a principal or an agent while facilitating any transaction because this will decide the amount that is entered in the accounting books and displayed in the financial statements. This in turn will affect the perception of stakeholders and decisions of management.
This article has been a guide to what is Revenue Recognition Principle. We explain it with examples, differences with revenue recognition agent, features & steps. You may learn more about accounting from the following articles –