The financial statements of a company reflect its financial position at the end of the reporting period and also the business performance for that period. The revenue recognition principle focuses on the fact that the revenues are recognized when they are realized or earned, irrespective of when the cash comes in. Revenue recognition principle along with the matching principle determines the accounting period during which revenues and expenses are recognized. For example, the telecom company Vodafone sells its prepaid talk-time through recharge cards; the company doesn’t recognize revenue until the customer makes calls and consumes the talk time.
Before we get into the details of revenue recognition, we do recommend you learn the basics of business finance with this course.
Revenue recognition principle forms the basis of accrual accounting, wherein the timing for the recognition income doesn’t coincide with the timing of receipt and payment of cash. The measurement of revenue has a great significance to the earnings management of an organization. It’s requires tough judgement calls. The criteria for recognizing revenue must be clearly defined and understood by the accounting department because even the slightest errors in judgement can lead to accounting frauds. If you overstate profits and assets by recognizing income before the earning process is complete or understate them by not recognizing income even after its meets the criteria, then it could mean serious violation of the revenue recognition principles.
Therefore, it’s imperative for business managers and accounting professionals to understand the basic principles of recognizing income and expenses. Here, we shall discuss the basic principles of revenue recognition to help you run your business in an efficient and transparent way. To learn more about accrual basis of accounting, take this course.
Revenue Recognition Criteria
Let’s understand the concept of revenue recognition with the help of an example. Say, a company XYZ which operates in the automobile industry, receives orders for cars from customers in advance with a 20% down payment. The company then takes 30 days to deliver the cars and collects the balance 80% of the car price on delivery.
In accordance with the revenue recognition principle, the company XYZ must not recognize any revenue till the delivery of the cars is complete because only then the risks and rewards of the vehicle ownership are fully transferred to the buyers.
Taking this example into consideration, let’s now examine the criteria for revenue recognition. According to IFRS standards, the criteria for recognizing revenue on the sale of products and services are as follows:
- The risks and rewards of the products have been completely transferred from the seller to the buyer. This means that the delivery has occurred or services have been rendered
- The seller doesn’t have any control over the goods or services sold
- Collection of payment (also called as collectability) is reasonably assured
- The revenue amount can be reasonably measured; in other words, the sellers’ price to the buyer cannot be changed
- Cost of earning the revenue can be reasonably measured
These 5 criteria are important in identifying the critical event for recognizing the revenue from the sale of products or services; therefore it’s called the Critical-Event approach to revenue recognition. For more insights on revenue measurement, skip ahead to this course on financial modelling. Out of these five criteria, the first two can be categorized into performance as the seller has performed the sale and the customer now owns the goods. The third criterion, as already indicated, comes under collectability since the amount needs to be received by the seller. Finally, the last two criteria can be categorized into measurability since the seller must substantiate the revenues earned with the expenses borne to make the sales. This is important from the point of view of the matching principle wherein the expenses and revenues must be matched by the seller; therefore they need to be reasonably measured.
Guidelines to Revenue Recognition
- If you receive advances for a sale, then they are not considered as revenue, but only as deferred income, until the following conditions are met:
a. Revenues are realized when the assets received upon sale are readily convertible to cash
b. Revenues are earned only when the products are sold or services have been rendered with payment assurance and delivery completion through
- We can broadly classify the various kinds of transactions for revenue recognition as:
a. Revenues from sale of inventory are recognized on the date of sale
b. Revenues from services are recognized only on the completion of the service and when the invoice is generated and sent
c. Revenue from usage of company assets (factory lease, royalties etc.) are recognized as and when the assets are used with the passage of time
d. Revenues from sale of other assets, apart from inventory, are recognized when they take place i.e. at point of sale
There are some exceptions to recognizing revenue from sale of assets other than the inventory, i.e. at point of sale, and they are as follows:
- Buyback agreements –this means that the company will buy the products back within certain period of time. In such a case, the buyback price will normally cover costs related to inventory and therefore the inventory remains in the seller’s stock.
- Returns – most e-commerce websites and online stores offer their customers the option of making returns; in such case, the company can recognize the revenues from the sales only when the time to return the product has expired.
The revenue recognition criteria help companies to reflect the true revenues earned during a period, which is different from the cash inflows as stated in the cash flow statement. Some revenues have to be realized before the sales such as long-term contracts or completion of production basis of transactions. Whatever the nature of your business and kind of sale transactions, as a business manager you must give utmost importance to revenue recognition so that there is no room for error or misstatements. Equip yourself with the accounting principles and revenue recognition criteria for a better understanding of your business performance.