OCW041: Revenue Recognition

The Importance of Timing: Revenue and Expense Recognition

Revenue is recognized when earned and payment is assured; expenses are recognized when incurred and the revenue associated with the expense is recognized.

Learning Objectives

Explain how the timing of expense and revenue recognition affects the financial statements

Key Takeaways

Key Points

  • According to the principle of revenue recognition, revenues are recognized in the period earned (buyer and seller have entered into an agreement to transfer assets ) and if they are realized or realizable ( cash payment has been received or collection of payment is reasonably assured).
  • The matching principle, part of accrual accounting, requires that expenses be recognized when obligations are (1) incurred (usually when goods are transferred or services rendered), and (2) that they offset recognized revenues, which were generated from those expenses.
  • As long as the timing of the recognition of revenue and expense falls within the same accounting period, the revenues and expenses are matched and reported on the income statement.

Key Terms

  • incur: To render somebody liable or subject to.
  • accrual accounting: refers to the concept of recognizing and reporting revenues when earned and expenses when incurred, regardless of the effect on cash.
  • matching principle: An accounting principle related to revenue and expense recognition in accrual accounting.

Revenues and Matching Expenses

According to the principle of revenue recognition, revenues are recognized in the period when it is earned (buyer and seller have entered into an agreement to transfer assets) and realized or realizable (cash payment has been received or collection of payment is reasonably assured).

For example, if a company enters into a new trading relationship with a buyer, and it enters into an agreement to sell the buyer some of its goods. The company delivers the products but does not receive payment until 30 days after the delivery. While the company had an agreement with the buyer and followed through on its end of the contract, since there was no pre-existing relationship with the buyer prior to the sale, a conservative accountant might not recognize the revenue from that sale until the company receives payment 30 days later.

Expense Recognition

The assets produced and sold or services rendered to generate revenue also generate related expenses. Accounting standards require that companies using the accrual basis of accounting and match all expenses with their related revenues for the period, so that the income statement shows the revenues earned and expenses incurred in the correct accounting period.

A Sample Income Statement: Expenses are listed on a company’s income statement.

The matching principle, part of the accrual accounting method, requires that expenses be recognized when obligations are (1) incurred (usually when goods are transferred, such as when they are sold or services rendered) and (2) the revenues that were generated from those expenses (based on cause and effect) are recognized.

For example, a company makes toy soldiers and acquires wood to make its goods. It acquires the wood on January 1st and pays for it on January 15th. The wood is used to make 100 toy soldiers, all of which are sold on February 15. While the costs associated with the wood were incurred and paid for during January, the expense would not be recognized until February 15th when the soldiers that the wood was used for were sold.

If no cause-and-effect relationship exists (e.g., a sale is impossible), costs are recognized as expenses in the accounting period they expired (e.g., when they have been used up or consumed, spoiled, dated, related to the production of substandard goods, or the services are not in demand). Examples of costs that are expensed immediately or when used up include administrative costs, R&D, and prepaid service contracts over multiple accounting periods.

The Effect of Timing on Revenues & Expenses

Often, a business will spend cash on producing their goods before it is sold or will receive cash for good sit has not yet delivered. Without the matching principle and the recognition rules, a business would be forced to record revenues and expenses when it received or paid cash. This could distort a business’s income statement and make it look like they were doing much better or much worse than is actually the case. By tying revenues and expenses to the completion of sales and other money generating tasks, the income statement will better reflect what happened in terms of what revenue and expense generating activities during the accounting period.

Current Guidelines for Revenue Recognition

Transactions that result in the recognition of revenue include sales assets, services rendered, and revenue from the use of company assets.

Learning Objectives

Explain how the revenue recognition principle affects how a transaction is recorded

Key Takeaways

Key Points

  • Under accrual accounting, revenues are recognized when they are realized (payment collected) or realizable (the seller has reasonable assurance that payment on goods will be collected) and when they are earned (usually occurs when goods are transferred or services rendered).
  • For companies that don’t follow accrual accounting and use the cash -basis instead, revenue is only recognized when cash is received.
  • Revenue recognition is a part of the accrual accounting concept that determines when revenues are recognized in the accounting period.
  • The matching principle, along with revenue recognition, aims to match revenues and expenses in the correct accounting period. It allows a better evaluation of the income statement, which shows the revenues and expenses for an accounting period or how much was spent to earn the period’s revenue.

Key Terms

  • fixed asset: Asset or property which cannot easily be converted into cash, such as land, buildings, and machinery.
  • intangible asset: Any valuable property of a business that does not appear on the balance sheet, including intellectual property, customer lists, and goodwill.

Revenue Recognition Concepts

The revenue recognition principle is a cornerstone of accrual accounting together with the matching principle. They both determine the accounting period in which revenues and expenses are recognized. According to the principle, revenues are recognized if they are realized or realizable (the seller has collected payment or has reasonable assurance that payment on goods will be collected). Revenues must also be earned (usually occurs when goods are transferred or services rendered), regardless of when cash is received. For companies that don’t follow accrual accounting and use the cash-basis instead, revenue is only recognized when cash is received.

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Presentation of Revenue Trends over Time: Guidelines for revenue recognition will affect how and when revenue is reported on the income statement.

Transactions that Recognize Revenue

Transactions that result in the recognition of revenue include:

  • Sales of inventory, which are typically recognized on the date of sale or date of delivery, depending on the shipping terms of the sale
  • Sales of assets other than inventory, typically recognized at point of sale.
  • Sales of services rendered, recognized when services are completed and billed.
  • Revenue from the use of the company’s assets such as interest earned for money loaned out, rent for using fixed assets, and royalties for using intangible assets, such as a licensed trademark. Revenue is recognized due to the passage of time or as assets are used.

The Matching Principle

The matching principle’s main goal is to match revenues and expenses in the correct accounting period. The principle allows a better evaluation of the income statement, which shows the revenues and expenses for an accounting period or how much was spent to earn the period’s revenue. By following the matching principle, businesses reduce confusion from a mismatch in timing between when costs (expenses) are incurred and when revenue is recognized and realized.

Recognition of Revenue at Point of Sale or Delivery

Companies can recognize revenue at point of sale if it is also the date of delivery or if the buyer takes immediate ownership of the goods.

Learning Objectives

Explain how the delivery date affects revenue recognition

Key Takeaways

Key Points

  • The accrual journal entry to record the sale involves a debit to the accounts receivable account and a credit to sales revenue; if the sale is for cash, debit cash instead. The revenue earned will be reported as part of sales revenue in the income statement for the current accounting period.
  • When transfer of ownership of goods sold is not immediate and delivery of the goods is required, the shipping terms of the sale dictate when revenue is recognized. Shipping terms are typically ” FOB Destination” and “FOB Shipping Point”.
  • If a company cannot reasonably estimate the amount of future returns and/or has extremely high rates of returns on sales, they should recognize revenues only when the right of return expires.

Key Terms

  • accrual: A charge incurred in one accounting period that has not been paid by the end of it.
  • FOB: Stands for “Free on Board” or “Freight on Board”; specifies which party (buyer or seller) pays for shipment and loading costs, and/or where responsibility for the goods is transferred.

Recognizing Revenue at Point of Sale or Delivery

Goods sold, especially retail goods, typically earn and recognize revenue at point of sale, which can also be the date of delivery if the buyer takes immediate ownership of the merchandise purchased. Since most sales are made using credit rather than cash, the revenue on the sale is still recognized if collection of payment is reasonably assured. The accrual journal entry to record the sale involves a debit to the accounts receivable account and a credit to the sales revenue account; if the sale is for cash, the cash account would be debited instead. The revenue earned will be reported as part of sales revenue in the income statement for the current accounting period.

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Street Market in India with Goods for Sale: A street market seller recognizes revenue when he relinquishes his merchandise to a buyer and receives payment for the item sold.

Terms of Delivery

When the transfer of ownership of goods sold is not immediate and delivery of the goods is required, the shipping terms of the sale dictate when revenue is recognized. Shipping terms are typically “FOB Destination” and “FOB Shipping Point”. For goods shipped under FOB destination, ownership passes to the buyer when the goods arrive at the buyer’s receiving dock; at this point, the seller has completed the sales transaction and revenue has been earned and is recorded. If the shipping terms are FOB shipping point, ownership passes to the buyer when the goods leave the seller’s shipping dock, thus the sale of the goods is complete and the seller can recognize the earned revenue.

Revenue Recognition & Right of Return

If a company cannot reasonably estimate the amount of future returns and/or has extremely high rates of returns on sales, they should recognize revenues only when the right of return expires. Those companies that 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.

Recognition of Revenue Prior to Delivery

Accrual accounting allows some revenue recognition methods that recognize revenue prior to delivery or sale of goods.

Learning Objectives

Distinguish between the percentage of completion method and the completion of production method of revenue recognition

Key Takeaways

Key Points

  • For most goods that have been sold and are undelivered, the sales transaction is not complete and revenue on the sale has not been earned. In this case, an accrual entry for revenue on the sale is not made.
  • The cash method of accounting recognizes revenue and expenses when cash is exchanged. For a seller using the cash method, if cash is received prior to the delivery of goods, the cash is recorded as earnings.
  • Under the percentage-of-completion method, if a long-term contract specifies the price and payment options with transfer of ownership and details the buyer’s and seller’s expectations, then revenues, costs, and gross profit can be recognized each period based upon the progress of construction.
  • The completion of production method allows recognizing revenues even if no sale was made. This applies to natural resources where there is a ready market for these products with reasonably assured prices, units are interchangeable, and selling and distributing costs are not significant.

Key Terms

  • conservatism: A risk-averse attitude or approach; for accounting purposes, it relates to disclosing expenses and losses incurred immediately and delaying the recognition of revenues and gains until realized.
  • accrual: A charge incurred in one accounting period that has not been paid by the end of it.

Definition of Revenue Recognition

The accounting principle regarding revenue recognition states that revenues are recognized when they are earned (transfer of value between buyer and seller has occurred) and realized or realizable (collection is reasonably assured). A transfer of value takes place between a buyer and seller when the buyer receives goods in accordance to a sales order approved by the buyer and seller and the seller receives payment or a promise to pay from the buyer for the goods purchased. Revenue must be realizable. In order words, for sales where cash was not received, the seller should be confident that the buyer will pay according to the terms of the sale.

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Goods in Inventory: Depending on the shipping terms of the sale, a seller may not recognize revenue on goods sold that are pending delivery.

Methods that Recognize Revenue Prior to Delivery or Sale

  • Percentage-of-completion method: if a long-term contract clearly specifies the price and payment options with transfer of ownership — the buyer is expected to pay the whole amount and the seller is expected to complete the project — then revenues, expenses, 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. Percentage of completion is preferred over the completed contract method. However, expected loss should be recognized fully and immediately due to the conservatism constraint. All revenues, expenses, losses, and gains resulting from the percentage completed will be reported on the income statement.
  • Completion of production method: This method allows recognizing revenues even if no sale was made. This applies to agricultural products and minerals because there is a ready market for these products with reasonably assured prices, the units are interchangeable, and selling and distributing does not involve significant costs. All expected revenues and costs of production related to the units produced will be reported on the income statement.

Recognition of Revenue After Delivery

There are three methods that recognize revenue after delivery has taken place: the installment sales, cost recovery, and deposit methods.

Learning Objectives

Differentiate between the installment sales method, the cost recover method and the deposit method to account for recognizing revenue after the delivery of goods

Key Takeaways

Key Points

  • When a sale of goods carries a high uncertainty on collectibility, a company must defer the recognition of revenue until after delivery.
  • The installment sales method recognizes income after a sale or delivery is made; the revenue recognized is a proportion or the product of the percentage of revenue earned and cash collected.
  • The cost recovery method is used when there is an extremely high probability of uncollectable payments. Under this method, no revenue is recognized until cash collections exceed the seller’s cost of the merchandise sold.
  • The deposit method is used when a company receives cash before transfer of ownership occurs. Revenue is not recognized when cash is received, because the risks and rewards of ownership have not transferred to the buyer. Only as the transfer of value takes place is revenue recognized.

Key Terms

  • deferral: An account where the asset or liability recording cash paid or received is not realized until a future date (accounting period)
  • liability: An obligation, debt or responsibility owed to someone.

Recognizing Revenue after Delivery of Goods

When a sale of goods transaction carries a high degree of uncertainty regarding collectibility, a company must defer the recognition of revenue. In this situation, revenue is not recognized at point of sale or delivery. There are three methods that recognize revenue after delivery has taken place:.

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Service Delivery: Delivery of goods or service may not be enough to allow for a business to recognize revenue on a sale if there is doubt that the customer will pay what it owes.

The installment sales method recognizes income after a sale or delivery is made; the revenue recognized is a proportion or the product of the percentage of revenue earned and cash collected. The unearned income is deferred (recorded as a liability ) and then recognized to income when cash is collected. For example, if a company collected 45% of a product’s sale price, it can recognize 45% of total revenue on that product. The installment sales method is typically used to account for sales of consumer durables, retail land sales, and retirement property.

The cost recovery method is used when there is an extremely high probability of uncollectable payments. Under this method, no revenue 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 recognizing revenue when the buyer has made payments in excess of $10,000. In other words, each dollar collected greater than $10,000 goes towards the seller’s anticipated revenue on the sale of $5,000.

The deposit method is used when a company receives cash before transfer of ownership occurs. Revenue is not recognized when cash is received because the risks and rewards of ownership have not transferred to the buyer. The seller records the cash deposit as a deferred revenue, which is reported as a liability on the balance sheet until the revenue is earned. For example, sales of magazine subscriptions utilize the deposit method to recognize revenue. A deferral is recorded when a seller receives a subscriber’s payment on the subscription; cash is debited and deferred magazine subscriptions (a liability account) is credited. As the delivery of the magazines take place, a portion of revenue is recognized, and the deferred liability account is reduced for the amount of the revenue.

Differences Between Accrual-Basis and Cash-Basis Accounting

Accrual accounting does not record revenues and expenses based on the exchange of cash, while the cash-basis method does.

Learning Objectives

Differentiate between accrual and cash basis accounting

Key Takeaways

Key Points

  • Accrual accounting does not consider cash when recording revenue; in most cases, goods must be transferred to the buyer in order to recognize earnings on the sale. An accrual journal entry is made to record the revenue on the transferred goods as long as collection of payment is expected.
  • In accrual accounting, expenses incurred in the same period that revenues are earned are also accrued for with a journal entry. Same as revenues, the recording of the expense is unrelated to the payment of cash.
  • For a seller using the cash method, revenue on the sale is not recognized until payment is collected and expenses are not recorded until cash is paid.
  • The cash model is only acceptable for smaller businesses for which a majority of transactions occur in cash and the use of credit is minimal.

Key Terms

  • accrue: To increase, to augment; to come to by way of increase; to arise or spring as a growth or result; to be added as increase, profit, or damage, especially as the produce of money lent.
  • liability: An obligation, debt or responsibility owed to someone.

Definition of Accrual Accounting

Under the accrual accounting method, the receipt of cash is not considered when recording revenue; however, in most cases, goods must be transferred to the buyer in order to recognize earnings on the sale. An accrual journal entry is made to record the revenue on the transferred goods even if payment has not been made. If goods are sold and remain undelivered, the sales transaction is not complete and revenue on the sale has not been earned. In this case, an accrual entry for revenue on the sale is not made until the goods are delivered or are in transit. Expenses incurred in the same period in which revenues are earned are also accrued for with a journal entry. Just like revenues, the recording of the expense is unrelated to the payment of cash. An expense account is debited and a cash or liability account is credited.

Definition of Cash-Basis Accounting

The cash method of accounting recognizes revenue and expenses when cash is exchanged. For a seller using the cash method, revenue on the sale is not recognized until payment is collected. Just like revenues, expenses are recognized and recorded when cash is paid. The Financial Accounting Standards Board (FASB), which dictates accounting standards for most companies—especially publicly traded companies—discourages businesses from using the cash model because revenues and expenses are not properly matched. The cash model is acceptable for smaller businesses for which a majority of transactions occur in cash and the use of credit is minimal. For example, a landscape gardener with clients that pay by cash or check could use the cash method to account for her business’ transactions.

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A cashier at a hotel in Thailand: The cash-basis method, unlike the accrual method, relies on the receipt and payment of cash to recognize revenues and expenses.


Source: Accounting