Revenue recognition

Revenue recognition principle is an important accounting principle, which is the main difference between cash basis accounting and accrual basis accounting. In cash basis accounting revenues are simply recognized when cash is received no matter when and how the services were performed or goods delivered. In accrual basis accounting revenues are recognized when they are (1) realized or realizable and (2) earned no matter when cash is received.

General rule

Revenues are realized when goods and services are exchanged for cash or claims to cash (that is, receivables). Revenues are realizable when assets received in exchange are readily convertible to known amounts of cash or claims to cash. Revenues are earned when the entity has performed its duties to be entitled to compensation.

There are 4 main transactions of this kind:
# Revenue from selling inventory is recognized at the date of sale (usually interpreted as the date of delivery).
# Revenue from performing services is recognized when services have been performed and are billable.
# Revenue from permission to use company’s assets (e.g. interests for using money, rent for using fixed assets, and royalties for using intangible assets) is recognized as time passes or as assets are used.
# Revenue from selling an asset other than inventory is recognized at the point of sale.

Revenue recognition criteria according to US GAAP

USSEC's SAB101 states that revenue generally is realized or realizable and earned when all of the following criteria are met:

# Persuasive evidence of an arrangement exists;
# Delivery has occurred or services have been rendered;
# The seller's price to the buyer is fixed or determinable; and
# Collectability is reasonably assured

Exceptions: revenues not recognized at delivery

The general rule says that revenue from selling inventory is recognized at the point of sale, but there are several exceptions.
* Buyback agreements: buyback agreement means that a company sells a product and agrees to buy it back after some time. If buyback price covers all costs of the inventory plus related holding costs, the inventory remains on the seller’s books. In plain: there was no sale.
* Returns: companies which cannot reasonably estimate the amount of future returns and/or have extremely high rates of returns should recognize revenues only when the right to return expires. Those companies which can estimate the number of future returns and have a relatively small return rate can recognize revenues at the point of sale, but must deduct estimated future returns.

Exceptions: revenues recognized before delivery

Long-term contracts

This exception primarily deals with long-term contracts such as constructions (buildings, stadiums, bridges, highways, etc.), development of aircraft, weapons, and space exploration hardware. Such contracts must allow the builder (seller) to bill the purchaser at various parts of the project (e.g. every 10 miles of road built).
* Percentage-of-completion method says that if (1) the contract clearly specifies the price and payment options with transfer of ownership, (2) the buyer is expected to pay the whole amount and (3) the seller is expected to complete the project, then revenues, costs, and gross profit can be recognized each period based upon the progress of construction (that is, percentage of completion). For example, if during the year, 25% of the building was completed, the builder can recognize 25% of the expected total profit on the contract. This method is preferred. However, expected loss should be recognized fully and immediately due to conservatism principle.
* Completed contract method should be used only if percentage-of-completion is not applicable or the contract involves extremely high risks. Under this method, revenues, costs, and gross profit are recognized only after the project is fully completed. Thus, if a company is working only on one project, its income statement will show $0 revenues and $0 construction-related costs until the final year. However, expected loss should be recognized fully and immediately due to conservatism principle..

Completion of production basis

This method allows recognizing revenues even if no sale was made. This applies to agricultural products and minerals because (1) there is a ready market for these products with reasonably assured prices, (2) the units are interchangeable, and (3) selling and distributing does not involve significant costs.

Deposits

Making a deposit is not considered to be a sufficient evidence of sale, thus no revenue or sale is recorded until the sale is completed (that is, the whole price is paid or the delivery). The deposit is recorded as a liability.

Exceptions: revenues recognized after delivery

Sometimes, the collection of receivables involves a high level of risk. It usually applies to sales when periodic payments must be made over an extended period of time (e.g. home equipment, industrial equipment). In such case revenue recognition is deferred until the cash is received. And there are two methods to deal with this situation:
* Installment sales method: it allows recognizing proportional gross profit on cash collection. For example, if a company collected 45% of total product price, it can recognize 45% of total profit on that product.
* Cost recovery method is used when there is an extremely high probability of uncollectible payments. Under this method no profit is recognized until cash collections exceed the seller’s cost of the merchandise sold. For example, if a company sold a machine worth $10,000 for $15,000, it can start recording profit only when the buyer pays more than $10,000. In other words, for each dollar collected greater than $10,000 goes towards your anticipated gross profit of $5,000.

ee also

*US GAAP
*Accounting methods
*Percentage-of-Completion method
*Completed contract method

References