Revenue recognition: 5 Step approach to Revenue Recognition

The revenue recognition principle is a cornerstone of accrual accounting together with the matching principle. They both determine the accounting period in which revenues and expenses are recognized. According to the principle, revenues are recognized when they are realized or realizable, and are earned (usually when goods are transferred or services rendered), no matter when cash is received. In cash accounting in contrast revenues are recognized when cash is received no matter when goods or services are sold.

The revenue recognition principle states that one should only record revenue when it has been earned, not when the related cash is collected.

Cash can be received in an earlier or later period than obligations are met (when goods or services are delivered) and related revenues are recognized that results in the following two types of accounts:

• Accrued revenue: Revenue is recognized before cash is received.
• Deferred revenue: Revenue is recognized when cash is received.

Revenue realized during an accounting period is included in the income.

Accounting for Revenue Recognition

If there is doubt in regard to whether payment will be received from a customer, then the seller should recognize an allowance for doubtful accounts in the amount by which it is expected that the customer will renege on its payment. If there is substantial doubt that any payment will be received, then the company should not recognize any revenue until a payment is received.

Also, under the accrual basis of accounting, if an entity receives payment in advance from a customer, then the entity records this payment as a liability, not as revenue. Only after it has completed all work under the arrangement with the customer can it recognize the payment as revenue.

Under the cash basis of accounting, you should record revenue when a cash payment has been received.

Conditions for Revenue Recognition

According to the IFRS criteria, for revenue to be recognized, the following conditions must be satisfied:

• Risks and rewards of ownership have been transferred from the seller to the buyer.
• The seller loses control over the goods sold.
• The collection of payment from goods or services is reasonably assured.
• The amount of revenue can be reasonably measured.
• Costs of revenue can be reasonably measured.

Steps in Revenue Recognition from Contracts

The five steps for revenue recognition in contracts are as follows:

1. Identifying the Contract

All conditions must be satisfied for a contract to form:

• Both parties must have approved the contract (whether it be written, verbal, or implied).
• The point of transfer of goods and services can be identified.
• Payment terms are identified.
• The contract has commercial substance.
• Collection of payment is probable.

2. Identifying the Performance Obligations

Some contracts may involve more than one performance obligation. For example, the sale of a car with a complementary driving lesson would be considered as two performance obligations the first being the car itself and the second being the driving lesson.

Performance obligations must be distinct from each other. The following conditions must be satisfied for a good or service to be distinct:

• The buyer (customer) can benefit from the goods or services on its own.
• The good or service is separately identified in the contract.

3. Determining the Transaction Price

The transaction price is usually readily determined; most contracts involve a fixed amount. For example, a price of Rs.20,000 for the sale of a car with a complementary driving lesson. The transaction price, in this case, would be Rs.20,000.

4. Allocating the Transaction Price to Performance Obligations

The allocation of the transaction price to more than one performance obligation should be based on the standalone selling prices of the performance obligations.

5. Recognizing Revenue in Accordance with Performance

Recall the conditions for revenue recognition. Conditions (1) and (2) state that revenue would be recognized when the seller has done what is expected to be entitled to payment. Therefore, revenue is recognized either:

• At a point in time;
• Over time

GAAP Revenue Recognition Principles

The Financial Accounting Standards Board (FASB) which sets the standards for U.S. GAAP has the following 5 principles for recognizing revenue:

• Identify the customer contract
• Identify the obligations in the customer contract
• Determine the transaction price
• Allocate the transaction price according to the performance obligations in the contract
• Recognize revenue when the performance obligations are met