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Revenue Recognition Principles

Revenue, which appears on the top line of income statement, is one of the most important measures of a company’s health to preparers, auditors, and users of financial statement.

What is revenue recognized?

Revenue Accounting is the process by which revenue is recorded in the books of accounts arising out of each transaction.

The process of Revenue Accounting has two different aspects as given below

a) Revenue Recognition: This refers to the timing of booking revenue entries for sale transactions. It is not always true that revenue has to be accounted when an Invoice is raised.

In case of contracts which entail services spanning more than a year, it is quiet possible that an Invoice is raised at the beginning or at the end though service will be delivered regularly through out the service contract period. In which case revenue has to be recognized only when the service obligation is delivered and not when the Invoice is raised. The required conditions as to when a revenue has to be accounted has been explained in detail, later in this document.

b) Determination of Revenue Accounts: This aspect is about determination of account code combinations to which revenue is to be posted.

Principle -> When is revenue recognized?

The revenue recognition principle is a cornerstone of accrual accounting together with matching principle

The general principles of revenue recognition are:

  1. the revenue can be measured reliably on account of sale of goods & services;
  2. it is probable that the economic benefits of the transaction will flow to the entity (collectability);
  3. the costs (both incurred to date and expected future costs) are identified and can be measured reliably

If any of the above criteria is missing, then the revenue recognition will have to be deferred until the conditions are met. For example, if a customer's credit worthiness is in doubt, then the revenue recognition should be deferred until the receipt in full or partial, of the balance due.

Whereas in cash accounting - in contrast - revenues are recognised when cash is received no matter when goods or services are sold.

When deferred needed

Those who are new to accounting exposure , can understand deferred means delay recognizing certain revenues or expenses on the income statement until a later, more appropriate time.

Revenues are deferred to a balance sheet liability account until they are earned in a later period. When the revenues are earned they will be moved from the balance sheet account to revenues on the income statement.

As per the primary revenue standards and revenue related interpretations that capture all revenue transactions, transactions generating revenue can be typically categorized in to four broad categories as below:

  • Sale of goods [Revenues from selling inventory are recognised at the date of sale often interpreted as the date of delivery]
  • Rendering of services [Revenues from rendering services are recognised, when services are completed and billed ]
  • Others’ use of an entity’s assets [Revenue from permission to use company’s assets (like interests for using money, rent for using fixed assets and royalties for using intangible assets) is recognised as time passes or as assets are used ]
  • Construction contracts

Accounting and Invoicing Rules

Senarios

Here is senario:

Total amount on the order is $6,200, out of which only $5,000 for the system will be recognized immediately with advanced invoicing. The price for ONE TIME INSTALLATION COST of $1,200 will be recognized over a period of next 12 months as shown below.

January 01 DR Receivable $6,200
CR Unearned Revenue $6,200

January 01 DR Unearned Revenue $5,000 Unearned Revenue $1,200
CR Revenue $5,000

January 01 DR Unearned Revenue $100 Unearned Revenue $1,100
CR Revenue $100

February 01 DR Unearned Revenue $100 Unearned Revenue $1,000
CR Revenue $100

March 01 DR Unearned Revenue $100 Unearned Revenue $900
CR Revenue $100

April 01 DR Unearned Revenue $100 Unearned Revenue $800
CR Revenue $100

May 01 DR Unearned Revenue $100 Unearned Revenue $700
CR Revenue $100

June 01 DR Unearned Revenue $100 Unearned Revenue $600
CR Revenue $100

July 01 DR Unearned Revenue $100 Unearned Revenue $500
CR Revenue $100

August 01 DR Unearned Revenue $100 Unearned Revenue $400
CR Revenue $100

September 01 DR Unearned Revenue $100 Unearned Revenue $300
CR Revenue $100

October 01 DR Unearned Revenue $100 Unearned Revenue $200
CR Revenue $100

November 01 DR Unearned Revenue $100 Unearned Revenue $100
CR Revenue $100

December 01 DR Unearned Revenue $100 Unearned Revenue $0
CR Revenue $100