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Revenue Recognition
Revenue Recognition
Revenue Recognition principle is one of the important principles of Accrual Accounting. According to this principle, revenue must be recognized when (1) They are realized or realizable and (2) They are earned Revenue is realized when products are exchanged for cash or claims to cash (Receivable). Revenue is realizable when related assets received are readily convertible to cash or claims to cash. Revenue is earned when the products are delivered or services are performed. Recognizing the revenue means recording the amount as revenue in the financial statements. Realization is the process of converting non-cash resources into cash. In the Revenue Recognition principle, it does not matter when cash is received. (In Cash Basis Accounting, revenue is recognized when cash is received no matter when goods or services are sold). For revenue to be recognized, both the above conditions must be met. In other words for revenue to be recognized, final delivery must be completed (of goods or services) and there has to be a payment assurance. Let us have a look at the timing of Revenue Recognition 1) For sale of finished goods (Inventory Items), revenue is recognized at the date of sale (some interpret this as the date of shipping or the date of delivery) 2) For sale of services (e.g. support services), revenue is recognized when the services are performed (delivered) 3) For sale of Asset Items (other than inventory items like finished goods), revenue is recognized at the point of sale (i.e. when the customer is invoiced) 4) For revenue from other activities like rent for using companys Fixed Assets, revenue is recognized as time passes or as assets are used.
Examples:
1) If a company invoices its customer for 100 units of item A, and ships (delivers) only 25 units, the company cannot recognize revenue for entire 100 items. It can only recognize revenue equivalent to the number of units delivered (Revenue is earned only when the products are delivered). Similarly, lets say you pay $120 in advance to company ABC for magazine subscription for one full year. The fact that company ABC received money for one full year
does not mean that they can record the entire amount as Revenue. In-fact the amount received in advance is a Liability to the company because they have to deliver magazines to their customer every month and if they fail to do so, they are liable to refund the amount received in advance. In this scenario, the company will recognize 1/12th of the entire amount every month as earned revenue after they deliver the magazine. 2) Company ZXC signs a 3 year support contract with its client for a total amount of 3 million. This amount cannot be recorded as revenue unless the Company provides the support services to the client. Assuming the company is following a monthly calendar accounting period, the company will recognize 1/36th of the entire support contract deal amount every month. (Revenue is recognized when services are performed) There are few exceptions to the timing of revenue recognition for sale of inventory items. Under normal scenario, revenue is recognizes at the point of sale, however if there are return policies, and if the company cannot reasonably estimate the amount of future returns, the revenue should be recognized only after the expiration of the return policy period.
1-Jan
Deferred Revenue
12000
End of Jan, Revenue is recognized for 1/12th of the entire amount, because the company has provided one months service to its client. To that effect, Deferred Revenue will be reduced and revenue will be recognized
Debit 1000
Credit
Comments Deferred Revenue reduced Earned Revenue amount for one month
1000
End of Feb, another months revenue is recognized Date 28-Feb 28-Feb Accounting Class Deferred Revenue Earned Revenue Debit 1000 1000 Credit Comments Deferred Revenue reduced Earned Revenue amount for one month
The company will have similar accounting entry each month till Dec. At the end of Dec, the Deferred Revenue will be Zero and the entire amount will be reported as Revenue earned.