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.
This would primarily result in two types of revenue recognition principles named as the Accrued revenue and the Deferred revenue accounts.
#1 – Accrued Principle of Revenue Recognition
source: Colgate SEC Filings
Under the accrual basis of accounting, the revenues are required to be recorded in the same accounting period in which it has been earned, irrespective of the timings of the related cash flows from that transaction.
If the seller is doubtful with respect to receiving the amount from the customer, he will recognize an allowance for doubtful accounts in the amount by which it is likely that the customer will 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 sheet of January 2017 and Rs.6,00,000 in revenue in the January income statement. Thus, it has been recorded that the company earned revenue in the month of January though it has actually 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 will, 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 revenue refers to the payments received in advance for the services that have not yet been rendered or for the goods that have yet not been delivered. If the company receives payment in advance, it is classified as a liability as it has received revenue for a service that has not been performed yet and that it is obliged to do so in future. The deferred revenue gets classified as an asset once the company has performed its duty of delivering the services or goods to the customer.
Salesforce.com deferred income is reported 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 prepayment of its monthly fee of Rs.300 in advance for a full year. This advance fee received is considered as deferred revenue 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 insurance, advance payment for newspaper subscription etc.
Criteria for Revenue Recognition
The five essential criteria for identifying the phenomenon pertaining to 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.
- 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 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 to receive 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 for Principle of revenue recognition, 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 with respect to 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 a number of years.
3) – Cost Recovery Method
As per the cost recovery method, 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 period 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 the 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 income as an asset. It is crucial to understand the principle of revenue recognition and properly account for the same.
This 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 –