Basically, by the rule, you should not recognize revenue until it has been earned. So, when is, exactly, a revenue considered as earned? You may ask. There are a number of rules regarding exactly when revenue can be recognized, but the key point is that revenue occurs at the point when substantially all services and deliveries related to the sale transaction have been completed.
If you’re around, in the accounting field, for long enough, you may find the term mentioned above is quiet broad.
I mean, you may find that, in certain circumstances, the rule seems to be unfits your specific situation. Through this post, I will overview various revenue recognition methods, all of which can be used under specific circumstances. You should be aware of which of the revenue recognition scenarios are most applicable to your situation, and report revenues accordingly. At the end of the post, I also will cover the revenue presentation. But before that, let’s have a look at the essential rules of the revenue recognition. Read on…
Essential Rules Of The Revenue Recognition
Within the broad requirement—mentioned on the preface of this post, here are three more prices rules, regarding revenue recognition:
1. Recognition at point of delivery – Under this term, you should recognize revenue when the product is delivered to the customer. For example, revenue is recognized in a retail store when a customer pays for a product and walks out of the store with it in hand. Alternatively, under a ‘Free on Board’ (FOB) term, a manufacturer recognizes revenue when its products are placed onboard a conveyance owned by a common carrier for delivery to a customer.
2. Recognition when customer acceptance is secured – The SEC issued Staff Accounting Bulletin Number 101 to prevent abusive revenue recognition. Under this rule, if there is any uncertainty about customer acceptance after a product or service has been delivered, for an example, then revenue SHOULD NOT be recognized until acceptance occurs. Customer acceptance is assumed not to have been secured at the point of delivery if the sales contract allows the customer to subsequently test the product, force the seller to make any additional post-delivery services, or specify any other work that is required before accepting the product. If customer acceptance cannot be secured, then revenue cannot be recognized until the time period during which the contractual acceptance provisions are in effect has lapsed.
3. Recognition at time of payment – If payment by the customer is not assured, even after delivery of the product or service has been completed, then the most appropriate time to recognize revenue is upon receipt of cash.
In addition to the above rules, there are a few others that should be applicable in all instances:
- Sellers should have no obligation to assist the buyer in reselling the product to a third party; if this were the case, then the seller would have an outstanding obligation to assist in further sales, which would imply that the initial sale had not yet been completed.
- Any damage to the product subsequent to the point of sale will have no impact on the buyer’s obligation to pay the seller for the full price of the product; if this were the case, one would reasonably assume that at least some portion of the sale price either includes a paid warranty that should be separated from the initial sale price and recognized at some later date, or that the sale cannot be recognized until the implied warranty period has been completed.
- The buying and selling entities cannot be the same entity, or so closely related that the transaction might be construed as an inter-company sale; if this were the case, the inter-company sale would have to be eliminated from the financial statements of both the buyer and the seller for reporting purposes, since the presumption would be that the sale had not really occurred.
Next, let’s have a look at various revenue recognition approaches for more specific circumstances. Read on…
This is known as the most common revenue recognition system is based on the accrual method. Under the accrual method, if the revenue recognition rules presented in the last section have been met, then revenue may be recognized in full. In addition, expenses related to that revenue, even if supplier invoices have not yet been received, should be recognized and matched against the revenue.
Note: The name of this method does not imply that the revenue should be accrued (such approach only applies to the accrual of expenses.)
Revenue recognition under the cash method simply means that revenues are recognized at the point when cash is received from a customer—which is still acceptable to the IRS for tax reporting purposes, but only in a limited number of cases and for smaller companies.
The cash basis of revenue recognition is not recognized as an acceptable reporting method by GAAP, since it does not match revenues to related expenses. Instead, the matching of revenues and expenses is entirely dependent upon the timing of cash receipts and expenses, which are subject to manipulation.
Actually, there is no difference between the accrual and cash methods if sales are over-the-counter, but there can be a significant difference if the majority of sales are billed to customers, for which payment is received at some later date.
Installment Sales Approach
When there is a long string of expected payments from a customer that are related to a sale—and for which the level of collectibility of individual payments cannot be reasonably estimated, the most appropriate approach to use is the “installment sales method.”
Under this approach, revenue is recognized only in the amount of each cash receipt, and for as long as cash is received. Expenses can be proportionally recognized to match the amount of each cash receipt, creating a small profit or loss at the time of each receipt.
This approach is particularly applicable in the case of multi-year payments by a customer.
Note: An alternative approach, called the “cost recovery method,” uses the same revenue recognition criterion as the installment sales method, but the amount of revenue recognized is exactly offset by the cost of the product or service until all related costs have been recognized—all remaining revenues then have no offsetting cost, which effectively pushes all profit recognition out until near the end of the installment sale contract.
Completed Contract Approach
I certain industries, especially the construction, the costs and revenues associated with a project cannot be reasonably tracked. Sometimes, there is some uncertainty regarding either the addition of costs to the project or the receipt of payments from the customer. In such situation, the completed contract approach is most make sense, compare to other approaches.
Under this approach, a construction company to wait until a construction project has been completed in all respects before recognizing any related revenue. However, this approach does not reveal the earning of any revenue on the financial statements of a construction company until its projects are substantially complete, which gives the reader of its financial statements very poor information about its ability to generate a continuing stream of revenues. Consequently, the percentage of completion method is to be preferred when costs and revenues can be reasonably estimated.
Percentage Of Completion Approach
This method is most commonly used in the construction industry, where very long-term construction projects would otherwise keep a company from revealing any revenues or expenses on its financial statements until its projects are completed, which might occur only at long intervals.
Under this approach, the accountant develops a percentage of project completion based on the total costs incurred as a percentage of the estimated total cost of the project, and multiplies this percentage by the total revenue to be earned under the contract (even if the revenue has not yet been billed to the customer). The resulting amount is recognized as revenue. The gross profit associated with the project is proportionally recognized at the same time that revenue is recognized.
The trouble with this approach is that one must have good cost tracking and project planning systems in order to ensure that all related costs are being properly accumulated for each project, and that cost overruns are accounted for when deriving the percentage of completion.
Proportional Performance Approach
In a service sales, when a number of specific and clearly identifiable actions are taken as part of an overall service to a customer, “proportional performance approach” is applied. Under this approach, one is allowed to proportionally recognize revenue as each individual action is completed.
The amount of revenue recognized is based on the proportional amount of direct costs incurred for each action to the estimated total amount of direct costs required to complete the entire service.
It is generally not allowable to record inventory at market prices at the time when production has been completed. However, this is allowed in the few cases where the item produced is a commodity, has a ready market, and can be easily sold at the market price. Examples of such items are gold, silver, and wheat. In these cases, the producer can mark up the cost of the item to the market rate at the point when production has been completed.
However, this amount must then be reduced by the estimated amount of any remaining selling costs, such as would be required to transport the commodity to market. In practice, most companies prefer to record the cost of commodities at cost, and recognize revenue at the point of sale. Consequently, this practice tends to be limited to those companies that produce commodities, but which have difficulty in calculating an internal cost at which they can record the cost of their production (and so are forced to use the market price instead).
When property is sold on a conditional basis, whereby the buyer has the right to cancel the contract and receive a refund up until a pre-specified date, the seller cannot recognize any revenue until the date when cancellation is no longer allowed. Until that time, all funds are recorded as a deposit liability.
If only portions of the contract can be canceled by the buyer, then revenue can be recognized at once by the seller for just those portions that are not subject to cancellation.
Bill and Hold Transactions Approach
There is certain situation, especially when the customers has no storage space available, companies resort to “bill and hold transactions,” under which it completes a product and bills the customer, but then stores the product rather than sending it to the customer (who may not want it yet).
The bill and hold transaction approach isn’t widely accepted. Consequently, the following rules must now be met before a bill and hold transaction will be considered valid:
- The terms of the sales agreement must not state that there are any unfulfilled obligations on the part of the seller at the time when revenue is recognized.
- The product that is being stored under the agreement must be ready for shipment.
- The products involved in the transaction must have been split away from all other inventory and stored separately. They must also not be made available for the filling of orders from other customers.
- The products cannot be stored indefinitely. Instead, there must be a schedule in place for the eventual delivery of the goods to the customer.
- The buyer must have signed a document in advance that clearly states that it is buying the products being stored by the seller.
- The buyer must have requested that the bill and hold transaction be completed, and have a good reason for doing so.
- The buyer must have taken on all risks of ownership, so that the seller is now simply the provider of storage space.
Revenue Recognition for Specific Transaction
1. Brokered Transactions – Some companies that act as brokers will over-report their revenue by recognizing not just the commission they earn on brokered sales, but also the revenue earned by their clients. This results in the appearance of enormous revenue (albeit with very small gross margins), which can be quite misleading. Consequently, one should apply the following rules to see if the full amount of brokered sales can be recognized as revenue:
- The broker must act as the principal who is originating the transaction.
- The broker must take on the risks of ownership, such as bearing the risk of loss on product delivery, returns, and bad debts from customers.
- The broker must obtain title to the product being sold at some point during the sale transaction.
2. Initiation Fees – A company may charge an initiation fee as part of a service contract, such as the up-front fee that many health clubs charge to new members. This fee should only be recognized immediately as revenue if there is a discernible value associated with it that can be separated from the services provided from ongoing fees that may be charged at a later date. For example, if a health club initiation fee allowed a new member access to the swimming pool area, which would not otherwise be available to another member who did not pay the fee, then this could be recognized as revenue. However, if the initiation fee does not yield any specific value to the purchaser, then revenue from it can only be recognized over the term of the agreement to which the fee is attached.
3. Accretion And Appreciation – Some company assets will grow in quantity over time, such as the timber stands owned by a lumber company. A case could be made that this accretion is a form of revenue, against which some company costs can be charged that are related to the accretion. However, this accretion in value is not one that can be recognized in a company’s financial reports. The reason is that no sale transaction has occurred that shifts ownership in the asset to a buyer. Some company assets, such as property or investments, will appreciate in value over time. For both accretion and appreciation, it is not allowable to record an unrealized gain in the financial statements; instead, the gain can only appear at the time of a sale transaction. The current accounting treatment tends to understate a company’s assets, since it restricts the recorded valuation to the original purchase price; however, the use of estimates to reflect increases in asset value could be so easily skewed by corporate officers striving to improve reported level of profitability.
Revenue is the inflow of funds or related accounts receivable or other assets from other business entities in exchange for the provision of products or services by a company. It may also include incidental revenues from financing activities, such as dividends, interest income, or rent, or through the sale of assets.
However, gains and losses that have little to do with the ongoing activities of the corporation (such as through an asset sale) should not be combined with revenues garnered from standard operations, because this would improperly show revenues that do not reveal the scale of ongoing operations.
A gain or loss on a transaction that is essentially unrelated to a company’s ongoing operations should not be recorded as revenue at the top of the income statement, but rather as a separate line item below the results of continuing operations. However, if the amount of the gain or loss is not material, it can be offset against other operating expenses and lumped into the results from continuing operations.
The “Other Income” category on the income statement typically includes all revenues not directly associated with operations, and that do not include gains or losses on other transactions. This category includes income from financing activities, such as dividends or interest income. It can also include any profits earned on the sale of those assets not normally offered for sale—typically fixed asset sales.