Numerous businesses use accounting principles to improve the consistency and reliability of accounting information. Accounting principles such as revenue and expense recognition can help business stakeholders make informed financial decisions. Some methods used in recognizing revenue include the completed contract method, cost recovery method, installment method, and percentage of completion method.
Revenue recognition standards differ for each company based on their accounting method, geographical location, whether they are a public or private entity, and other factors. The revenue recognition principle, a key feature of accrual-basis accounting, determines that companies acknowledge revenue as it is earned (not when they receive payment). Accurate revenue recognition directly affects the integrity and consistency of a company’s financial reporting, so it is essential to businesses.
What is Revenue Recognition?
Revenue recognition is a generally accepted accounting principle (GAAP) that dictates how and when revenue is recognized. For business transactions, companies usually earn and recognize revenue when they sell a product or service. If a customer pays for a service in advance, the company will not count that money as revenue. The money will not be considered until the service is finished. The revenue recognition principle declares that a company acknowledges revenue during the period when the buyer and seller agree to transfer assets. The company realizes the revenue or receives payment too.
Why is the Revenue Recognition Principle Important?
The revenue recognition principle is important since it offers a customary way for all companies to track and manage their profitability. Companies must account for their revenue or income and their expenses or costs. That means that external entities (analysts and investors) can easily compare the income statements of different businesses in the same industry. Since revenue is one of the most significant measures investors use to assess a company’s performance, financial statements must be as credible and logical as possible.
What are the Most Common Methods of Revenue Recognition?
There are multiple ways organizations can recognize revenue on an income statement. The method chosen depends on the industry and circumstances. The following are the most common recognition methods:
Completed Contract Method
Recognizes all of the revenue and profit associated with a project only after it has been completed. Companies use this method when there is uncertainty about the collection of funds a customer owes under contract terms.
Cost Recovery Method
A business does not recognize any profit related to a sale transaction until the cost element of the sale has been paid in cash by the customer. Once the cash payments have recovered the seller’s costs, all the remaining cash receipts (if they exist) are recorded in income as received. Typically, this approach is used for uncertainty about the collection of a receivable.
When sellers allow customers to pay for sales over multiple years, the transaction is often accounted for by sellers using the installment method. This especially applies where it is not possible to determine cash collectability from customers. This is an ideal method for large-dollar items, such as real estate, machinery, and consumer appliances.
Percentage of Completion Method
The percentage of completion method consists of the ongoing acknowledgment of revenue and profits related to longer-term projects. Therefore, the seller can recognize some gain or loss regarding a project in every reporting period it is active. This method is best for situations where it is possible to estimate the stages of project completion on an ongoing basis. Or to at least estimate the remaining costs to complete a project.
Under this approach, sales are recognized at the time of sale. The sales-basis method is applicable when payment is assured and all deliverables have been made. Most types of retail sales use the sales-basis method.
What are the Five Steps Required to Comply with the Revised Revenue Recognition?
The revenue recognition standard has been updated to be industry-neutral and more transparent. It offers improved comparability of financial statements with standardized revenue recognition practices across multiple industries.
The five steps required to comply with the revised revenue recognition principle are:
- Identify the agreement with the client
A contract is an agreement between the buyer and seller. It allows everyone to understand each other’s obligations according to the terms. Since you can write contractual terms, discuss them verbally, or imply them, companies and individuals may decide to exercise extra caution with customers. This step ensures that the contracts are legally binding.
- Identify the performance obligation of the contract
Determine all of the commitments you made to the customer that are promised in the agreement. The commitments include transferring goods or services or a series of goods and services that are the same and use the same delivery arrangement. For instance, a retailer enters a contractual promise to sell and deliver a tv to someone’s house. The retailer has a performance obligation to transfer the tv to the customer for the agreed price.
- Determine the price
Selling entities set the price of goods and services based on the consideration expected other than the contract amount. Since the contract price might include other variable considerations like discounts and rebates due to a customer or the selling entities, the standard rule is to gauge the variables. Make sure you consider them at the beginning of the contract.
- Allocate the transfer price to the performance obligation
You have to allocate the transaction price to each performance obligation separately because some contracts will consist of several performance obligations. If there are any variable considerations, companies have to allocate them. Businesses use physical information to decide a selling price for stand-alone goods or services if observation information is unavailable.
- Recognize revenue
You can realize revenue at multiple points. Some instances are when a customer makes a payment at a certain period in the contract terms, once they gain control of the goods, or when they agree your services are satisfactory.
How Does GAAP Regulate Revenue Accounting?
GAAP requires that revenues are acknowledged according to the revenue recognition principle (a feature of accrual accounting). Meaning, that revenue is recognized on the income statement in the period when it is realized and earned, not always when cash is received. The revenue-generating activity must be wholly or essentially complete to be included in revenue during the appropriate accounting period. Additionally, there must be a reasonable certainty level that earned revenue payment be received. And lastly, based on the matching principle, the revenue and its associated costs have to be prepared in the same accounting period.
How is Revenue Recognized Calculated?
Most companies use the standard way to calculate revenue recognized. The most simple formula for it is:
The number of units sold x average price
Another way is:
The number of customers x average price per unit provided
Calculating revenue is straightforward, but accountants can adjust the numbers as needed. They can do it in a legal way that causes curious parties to delve deeper into the financial statements to get a better understanding of revenue generation. Investors especially need this since they have to know not just a company’s revenue, but what affects it quarterly to quarter.
How Does the IFRS Define Revenue?
The IFRS defines revenue when it meets the following conditions:
- Risk and rewards have been transferred from the seller to the buyer.
- Seller has no control over goods sold.
- The collection of payment from goods or services is reasonably assured.
- Amount of revenue can be reasonably measured.
- Cost of revenue can be reasonably measured.
All of these conditions fall under three categories that the IFRS deems necessary for a contract to exist: performance, collectability, and measurability. The first two conditions fall under “performance,” which is achieved when the seller has done most or all of what they are supposed to do to be entitled to payment. The third condition belongs to “collectability,” meaning that the seller must have a reasonable expectation of being paid. For the last two, they are “measurability” conditions because of the matching principle (the seller must be able to match expenses to the revenues it helped earn). Thus, the number of revenues and expenses should both be reasonably measurable.
When should Revenue be Recognized as Earned?
Revenues should be recognized as earned when the earning process has been substantially completed. Suppose a merchandiser’s sales revenues are considered earned when the goods have been shipped or delivered to customers. The merchandiser has a right to collectible accounts receivable as well. This is due to the substantial and difficult parts of the selling process being complete. Some of these parts include: having the merchandise, finding customers, getting customers to place orders, and delivering the merchandise to customers. Collecting the accounts receivable is usually an automatic process that requires little to no effort.
Is it Important for Small Businesses to Understand Revenue Recognition?
It is important for small businesses to understand revenue recognition and its related principles. While many smaller companies are private and do not need to follow GAAP, many still adhere to the standard. GAAP financial statements are often understood by lenders and investors, providing credibility to the financial reporting and the company as a whole. So, having GAAP-compliant revenue recognition practices and financial statements can offer more financing options and sources. These options often come at a lower cost making it simpler to build and expand a business.
For companies considering going public in the future, already abiding by GAAP can help ease the transition. When private companies go public, they will have to acquire various things. Some changes they can expect are different ownership and capital structure, investors with distinct investment strategies, typically more accounting resources, and limited investor access to management. Hence, the company must immediately meet the regulatory requirements in which it is filing, which may include submitting GAAP financial statements to the U.S. Securities and Exchange Commission (SEC).