Principles of Revenue Recognition
Income statement is constructed using the principles of accrual accounting. Under accrual account, the revenue is recognized when earned and expenses are recognized when incurred.
According to the revenue recognition principle, a company recognizes revenue only when it is earned once the goods are delivered or when the service is completed. So, if a retailer sells a laptop to you in June, the retailer will recognize the revenue in June itself. However, take the case of a manufacturer, who receives an order in June, delivers the goods in July, and receives the payment in August. When should he recognize the revenue? The answer is July when it delivered the goods. Bothe IASB and FASB have described when revenue can be recognized in case of sale of goods as well as rendering of services.
IASB: Revenue Recognition
IAS 18 provides guidance for recognising the following specific categories of revenue:
Sale of goods
Revenue arising from the sale of goods should be recognised when all of the following criteria have been satisfied: [IAS 18.14]
- The seller has transferred to the buyer the significant risks and rewards of ownership
- The seller retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold
- The amount of revenue can be measured reliably
- It is probable that the economic benefits associated with the transaction will flow to the seller, and
- The costs incurred or to be incurred in respect of the transaction can be measured reliably
Rendering of services
For revenue arising from the rendering of services, provided that all of the following criteria are met, revenue should be recognised by reference to the stage of completion of the transaction at the balance sheet date (the percentage-of-completion method): [IAS 18.20]
- The amount of revenue can be measured reliably;
- It is probable that the economic benefits will flow to the seller;
- The stage of completion at the balance sheet date can be measured reliably; and
- The costs incurred, or to be incurred, in respect of the transaction can be measured reliably.
When the above criteria are not met, revenue arising from the rendering of services should be recognised only to the extent of the expenses recognised that are recoverable (a "cost-recovery approach". [IAS 18.26]
FASB: Revenue Recognition
According to FASB Statement of Financial Accounting Concepts No. 5, revenue is recognized when a transaction occurs, and
- The revenue is realized or realizable
- The revenue is earned
Revenue from a transaction must meet both criteria in order to be recognized. Revenue is generally considered realized when cash is received for the sale of a product or performance of a service. Revenue generally becomes realizable when a promise to pay is received in exchange for the sale of a product or performance of a service. The promise to pay could be verbal (account receivable) or written (note receivable). Revenue is generally earned when a legally enforceable exchange takes place (e.g., consideration has been tendered and the buyer takes possession of the product or benefits from the performance of a service).
SEC: Revenue Recognition
The Securities and Exchange Commission also provides guidance on revenue recognition. According to SEC guidelines, the two criteria (‘realized or realizable’ and ‘earned’) are met when all of the following criteria are established:
- Persuasive evidence of an arrangement exists.
- Delivery has occurred or services have been rendered.
- The seller’s price to the buyer is fixed or determinable.
- Collectability is reasonably assured.
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