Principles of Revenue Recognition
The principle of revenue recognition is a generally accepted accounting principle (GAAP) that outlines the specific conditions under which the revenue is recognized or is accounted for. Cash may be received at an earlier stage or at a later date after the goods and services have been delivered to the customer and the revenue gets recognized.
It would primarily result in two types of revenue recognition principles named as 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.
If the seller is doubtful concerning receiving the amount from the customer, he will recognize an allowance for doubtful accounts in the amount by which the customer will likely default on the payment.
A company named 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 refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet., in turn, be converted to cash when the payment is received from the respective customer.
#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. If a company receives advance payment, it classifies as a liability, as the service is not yet performed, and it needs to be delivered in the future. The deferred revenue classifies as an asset once the company delivers the services or goods to the customer.
Salesforce.com reported its deferred income under the current liability section. It is $7,094,705 in FY2018 and $5,542,802 in FY2017.
A cleaning company named XYZ Ltd. has committed to providing services to a customer. The company accepted the prepaymentPrepaymentPaying off an expense or debt obligation before the due date is referred to as prepayment. Companies frequently pay for expenses, goods, and services in advance to reduce their financial burden and gain monetary rewards. Prepaid bills, rent, salary, credit card bills, income tax, and sales tax are all examples of prepayment. of its monthly fee of Rs.300 in advance for a full year. This advance fee received 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.
Criteria for Revenue Recognition
The five essential criteria for identifying the phenomenon about revenue recognition on the sale of goods as provided by IFRS 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 is required to 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 be able to match the revenues to the expenses as per the matching principle concept.
Methods for Revenue Recognition
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 the completion of the transaction. This method is generally used when there 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.
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 as well as guards against treating 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 Principle of revenue recognition and properly account for the same.
This article has been a guide to Revenue Recognition Principles. Here we discuss the two types of principles in revenue recognition, namely accrued and deferred revenue accounts, along with methods to recognize revenues. You may learn more about accounting from the following articles –