Overview of Revenue Recognition Principle
As the name suggests, the revenue Recognition Principle is an accounting standard used in both IFRS and GAAP that illustrates the specific conditions in which a business can recognize revenue. Any business operating in any country must follow either the revenue recognition principle as illustrated in IFRS or GAAP standards.
Criteria of Revenue Recognition
According to the standards illustrated in IFRS for recognition of revenue, the following criteria need to be satisfied:
- Risks and rewards have been passed on from the seller to the buyer.
- Revenue can be recognized when the seller has no control over the sold goods.
- There is reasonable assurance over the collection of payment for goods sold.
- There can be a reasonable measurement of the amount of revenue received.
- There can be a reasonable measurement of costs of revenue.
Criteria 1 and 2 refer to the Performance of the business. It implies that the seller has done what is necessary for it to be entitled to payment.
Criteria 3 refers to the Collectability of the business. It implies that the seller has a reasonable expectation that it will be paid for the performance of the business.
Criteria 4 and 5 refer to the Measurability of the business. As per the matching principle, the seller must be able to match its revenues to its expenses. Hence there is a reasonable assumption that both revenues and expenses can be reasonably measured.
Requirement of Revenue Recognition Principle
It is understandable that revenue is the heart of the soul for any business. Higher revenues indicate that the company is performing better. Hence, companies may likely try to modify their accounts to show a higher collection of revenues. So the regulators have set certain guidelines that need to be adhered to by companies while preparing their annual reports for disclosure so that the proper performance of the company is conveyed to the investors and shareholders. Also if there is a set standard that needs to be followed, then analysts and investors can compare similar accounting principles to judge whether the company is performing better than its peers or not.
Example of Revenue Recognition Principle
- SMAASH Bowling Alley sells one of its assets to another player on December 31 for $100000. The asset was not paid for until January 20th, and the asset was delivered on January 31. Since the sale happened on December 31 but not paid for until January, the revenue is not earned until January 20th.
- PwC does consult work for Apple and provides certain services. During the month of December, it provided work of $10000, but Apple pays for the consulting work in January. Hence according to the revenue recognition principle, PwC should recognize the revenue in December since it did consulting work in December even if the payment did not happen till January.
- Zara sells clothing from its various retail outlets all over the world. A customer purchased some item of clothing on the 1st of June and pays using his credit card. The transaction happened in June, but the amount is received from the credit card company in July. Since the purchase from the credit card is treated as cash under the revenue recognition principle hence, the revenue should be recorded in the month of June by Zara.
Revenue Recognition from Contracts
IFRS 15 deals with revenue recognition from contracts. There are some specific exclusions of contracts that are not under the revenue recognition principle:
- Lease Contracts which are specified in IAS 17.
- Insurance Contracts which are specified in IFRS 4.
- Financial Instruments which are specified in IFRS 9.
The various steps in revenue recognition from contracts are:
1. Identifying the contract
All the criteria must be fulfilled for a contract to form:
- Both the counter parties must have agreed to the contract.
- The point of transfer for either goods and services must be identifiable.
- Specific terms of payment can be identified.
- There must be a commercial substance in the contract.
- There is a probability of collection of payment.
2. Identifying the performance obligations
The obligations for performance must be distinct and identifiable.
The following criteria should be met:
- The buyer of the product or service must benefit from the purchase.
- The product or the service of the seller must be specified in the contract.
3. Determining the price of the transaction
- The transaction price must be clearly identified in the contract.
- As such most of the contracts have a fixed amount, but this is not mandatory.
4. Linking the transaction price to the performance obligations
- The transaction price for one or more performance obligations must be allocated based on the standalone selling prices specified in the contract.
5. Revenue recognition based on performance
- Revenue for various performance obligations may be recognized at a point in time or over a period of time and must satisfy criteria 1 and 2 specified in the revenue recognition principle.
As the name suggests, the revenue Recognition Principle is an accounting standard used in both IFRS and GAAP that illustrates the specific conditions in which a business can recognize revenue recognized in a year is important for any company to illustrate better performance; hence there are chances that revenue recognition might be misstated. Hence set standards have been developed to ensure that every company follows the guidelines, and analysts can compare companies based on those guidelines.
This is a guide to Revenue Recognition Principle. Here we discuss revenue recognition with the key points such as criteria, requirements, and example. You may also look at the following articles to learn more –