What is the revenue recognition principle?
The revenue recognition principle says that revenue should be recorded when it has been earned, not received. The revenue recognition concept is part of accrual accounting, meaning that when you create an invoice for your customer for goods or services, the amount of that invoice is recorded as revenue at that point, and not when the money is received from the customer.
This is one of the major differences between accrual basis accounting and cash basis accounting, since with cash accounting, revenue is recognized when payment is received, not when it’s earned.
What does the revenue recognition principle mean for businesses?
The revenue recognition principle enables your business to show profit and loss accurately, since you will be recording revenue when it is earned, not when it is received.
Using the revenue recognition principle also helps with financial projections; allowing your business to more accurately project future revenues. Recognizing revenue properly is also important for businesses that receive payment in advance of services, such as businesses that provide service contracts that require payment up front.
In order to recognize revenue properly, any business that receives payment upfront for services to be rendered must recognize that revenue only after the services have been performed. For instance, if you offer a yearly support contract to your customers for $12,000annually, you will recognize revenue in the amount of $1,000 monthly for the next 12 months.
ACCOUNT NAME & DESCRIPTION
Cash - To record prepayment
Client Prepayment - To record prepayment
This is to record the initial customer deposit of $12,000.
In this Example, you would debit your cash account, since the money will be deposited. However, instead of applying it to an income account, you would place it in a Client Prepayment account, which will be gradually reduced until the complete $12,000 has been earned.
Requirements for revenue recognition
The revenue recognition principle requires that you use double-entry accounting. Here are some additional guidelines that need to be followed in regard to the revenue recognition principle:
1. An arrangement or agreement is in place between your business and your customer. What this means is that you have offered credit terms to your customer, and they have agreed to pay the invoice in the amount of time in order to fulfill those terms. For instance, you provide consulting services to Client A, with credit terms of Net 30. If Client A accepts those terms, they agree to pay your invoice within 30 days of the date of the invoice.
2. The product or service that you are selling has been delivered or completed. This is one of the most important components of the revenue recognition principle, which is that revenue is recognized and recorded when services are rendered, or the product delivered. In essence, this means that your portion of the agreement is complete.
3. The cost has been determined. When you offer your services or sell products to clients, you must provide them with the cost of those services or products, with the cost finalized prior to recognizing the revenue.
4. The amount billed is collectible. This is straightforward and speaks to the importance of accurately vetting clients to determine their creditworthiness. Before you offer credit terms to clients, you should be reasonably sure that you can collect the balance due from them at a future date. This is not foolproof of course, because even properly vetted companies can pay their bills late at times, but this should be the exception, not the rule.
5. If you have doubts about the collectability of an invoice, it should not be recognized as revenue. This is a tough one, since it’s unlikely that you will extend credit terms to a customer that you don’t think will be able to pay their bill. However, if this issue does arise, you should delay recognizing the revenue until the bill has been paid.
6. If payment is received in advance of products or services, the revenue should be recognized only after services are rendered. For instance, if your business provides office cleaning services for $500 a month, and your customer pays you$1,500 for the next three months, the revenue would be recognized at $500 for the next three accounting cycles, rather than being recognized in total for the current accounting cycle.
Revenue Recognition Criteria
According to IFRS standards, all of the following five conditions must be met for a company to recognize revenue:
· There is a transfer of the risks and rewards of ownership.
· The seller loses continuing managerial involvement or control of the goods sold.
· The amount of revenue can be reasonably measured.
· Collection of payment is reasonably assured.
· The costs incurred can be reasonably measured.
Revenue recognition methods
There are a number of ways in which revenue can be recognized in an organization's income statement. The method chosen depends on the industry and the specific circumstances. In the following sections, we note a number of recognition methods, how they work, and when they can be used.
1. Completed Contract Method
The completed contract method is used to recognize all the revenue and profit associated with a project only after the project has been completed. This method is used when there is uncertainty about the collection of funds due from a customer under the terms of a contract.
2. Cost Recovery Method
Under the cost recovery method, a business does not recognize any profit related to a sale transaction until such time as 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 remaining cash receipts (if any) are recorded in income as received. This approach is to be used when there is considerable uncertainty regarding the collection of a receivable.
3. Installment Method
When a seller allows a customer to pay for a sale over multiple years, the transaction is frequently accounted for by the seller using the installment method - and especially where it is not possible to determine the collectability of cash from the customer. Someone using it defers the gross margin on a sale transaction until the actual receipt of cash. This is an ideal recognition method for large-dollar items, such as real estate ,machinery, and consumer appliances.
4. Percentage of Completion Method
The percentage of completion method involves, as the name implies, the ongoing recognition of revenue and profits related to longer-term projects. By doing so, the seller can recognize some gain or loss related to a project in every reporting period in which the project continues to be active. The method works best when it is reasonably possible to estimate the stages of project completion on an ongoing basis, or at least to estimate the remaining costs to complete a project. In essence, the percentage of completion method allows you to recognize as income that percentage of total income that matches the percentage of completion of a project.
5. Sales-Basis Method
Under the sales-basis approach, sales are recognized at the time of sale. This method works best when payment is assured, and all deliverables have been made. The sales-basis method is used for most types of retail sales.
6. Problems with Revenue Recognition Methods
The problem with revenue recognition is that many companies are valued based on the revenues they report, so there is an incentive to report excessively high revenue levels. This can take many forms, such as applying more generous recognition methods that do not really apply to a company’s circumstances or making use of gray areas of the regulations to falsely accelerate the reporting of revenue. Given these concerns, auditors tend to allocate more of their time to the examination of clients’ revenue recognition methods.
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