What is Revenue Recognition?

Revenue recognition is a generally accepted accounting principle that identifies the specific conditions in
which revenue is recognized and determines how to account for it. Typically, revenue is recognized when
a critical event has occurred, and the dollar amount is easily measurable to the company.

For example, revenue accounting is fairly straightforward when a product is sold, and the revenue is
recognized when the customer pays for the product. However, accounting for revenue can get
complicated when a company takes a long time to produce a product. As a result, there are several
situations in which there can be exceptions to the revenue recognition principle
Understanding of Revenue Recognition
Revenue is at the heart of all business performance. Everything hinges on the sale. As such, regulators
know how tempting it is for companies to push the limits on what qualifies as revenue, especially when
not all revenue is collected when the work is complete.

For example, attorneys charge their clients in billable hours and present the invoice after work is
completed. Construction managers often bill clients on a percentage-of-completion method. As a result,
analysts prefer that the revenue recognition policies for one company are also standard for the entire
industry.

Having a standard revenue recognition guideline helps to ensure that an apples-to-apples comparison can
be made between companies when reviewing line items on the income statement. Revenue recognition
principles within a company should remain constant over time as well, so historical financials can be
analyzed and reviewed for seasonal trends.
The Current Environment
Guidelines for Revenue Recognition:

Revenue arises from ordinary operations and is referred to by various names such as sales ,fees, rent ,
interest ,royalties and service revenue Gains, on the other hand may or may not arise in the normal course
of operations .Typical gains or gains on sale of noncurrent assets s or unrealized gains related to
investment or noncurrent asset. The primary issued related to revenue recognition is when to recognized
the revenue.

The revenue recognition principle developed by the FASB and IASB in a recent exposure drafts indicates
the companies recognized revenue in the accounting period when a performance obligation is satisfied.
Until new revenue recognition rules are adopted, existing GAAP guidelines for revenue recognition are
quit broad. On top of the broad

guidelines, certain industries have specific additional guidelines that provide further insight into when
revenue should be recognized. The revenue recognition principle under current GAAP provides that
company should recognized revenue. When it is realized or realizable and when it is earned.

Therefore, proper revenue recognition revolves around three terms:

• Revenues are realized when a company exchanges goods and services for cash or claims to cash.

• Revenues are reliable when assets a company receives in exchange

are readily convertible to know amounts of cash or claims to cash.

• Revenues are earned when a company has substantially

accomplished what it must do to be entitled to the benefits

represented by the revenues-that is ,when the earnings process is

complete or virtually complete.

 Four types of revenue Transaction
Four revenue transactions are recognized in accordance with this principles:

1. Companies recognize revenue from selling products at the date of sale. This date is usually
interpreted to mean the date of delivery to customers.

2. Companies recognize revenue from services provided, when services have been performed
and are available.

3. Companies recognize revenue from permitting others to use enterprise assets, such as interest,
rent, royalties, as time passes or as the assets are used.

4. Companies recognize revenue from disposing of assets other than products at the date of sale.

5.Revenue Recognition Classified by Nature of transactions

Revenue Recognition Before Delivery

Costs incurred to date = Percent complete Most recent estimated total costs

Estimated total revenue x Percent complete = Revenue to be recognized to date

Total revenue to be recognized to date less Revenue recognized in PRIOR periods = Current
period revenue

Current Period Revenue less current costs = Gross profit

The Installment Sales Method: For Example

Data: Contract price: $4,500,000 Estimated cost: $4,000,000

Start date: July, 2003 Finish: October, 2005

Balance sheet date: Dec. 31

Given: 2003 2004 2005

Costs to date $1,000,000 $2,916,000 $4,050,000

Estimated costs to complete $3,000,000 $1,134,000 $ -0-

Progress Billings during year $900,000 $2,400,000 $1,200,000

Cash collected during year $750,000 $1,750,000 $2,000,000

What is the percent complete, revenue and gross profit recognized each year

2003 2004 2005

% complete to- 4000000/1000000 4500000/2916000 100%
date =25% =72%
Revenue 4500000*25%=1125000 4500000*72% 4500000*100%
Recognized =3240000 =4500000
Current period =1125000 3240000 4500000
revenue =2115000 =1125000 3240000
1260000
Gross profit 1125000-1000000 2115000-1916000 1216000-
recognized =125000 =199000 1126000
=126000
Recognizing Current & Overall Losses on Long-Term
Contracts
A long-term contract may produce:

• either an interim loss and an overall profit,

• or an overall loss for the project
Under the percentage-of-completion method, losses in any case are immediately
recognized.

Under the completed contract method, losses are recognized immediately only when
overall losses are indicated.

Revenue Recognition After Delivery

Revenue recognition is deferred when collection of sales price is not reasonably assured and no
reliable estimates can be made.

The two methods that are used are:

• the installment sales method

• the cost recovery method

If cash is received prior to delivery, the method used is the deposit method.

The Installment Sales Method

• This method emphasizes income recognition in periods of collection rather than at point
of sale.

• Title does not pass to the buyer until all cash payments have been made to the seller.

• Both sales and cost of sales are deferred to the periods of collection.

• Other expenses, selling and administrative, are not deferred.

The installment sell method: Steps
• For installment sales in any year

•For installment sales made in prior years (realized gross profit Determine rate of gross profit on
installment sales

• Apply this rate to cash collections of current year’s installment sales to yield realized gross
profit

• The gross profit not realized is deferred

• Apply the relevant rate to cash collections of prior year’s installment sales

The Installment Sales Method: Example

Given:

2003 2004 2005

Installment sales $200,000 $250,000 $240,000

Cost of sales $150,000 $190,000 $168,000

Gross Profit $ 50,000 $ 60,000 $ 72,000

Cash received in;

from 2003 sales $60,000 $100,000 $40,000

from 2004 sales $ -0- $100,000 $125,000

from 2005 sales $-0- $-0- $80,000

Determine the realized and deferred gross profit.

The Installment Sales Method: Example
Given: 2003 2004 2005
Installment sales $200,00 $250,000 $240,000
Gross Profit$ 50,000 $60,000 $72,000
Gross profit rate 25% 24% 30%

The Installment Sales Method: Example

2003 2004 2005

Gross profit rate 25% 24% 30%

Realized Gross Profit:

From 2003 sales:

Realized in $15,000 $ 25,00 $10,000

From 2004 sales:

Realized in: $-0- $ 24,000 $30,000

From 2005 sales:

Realized in: $ -0- $-0- $24,000