Revenue Recognition Principle: Definition & Importance

The revenue recognition principle dictates the process and timing by which revenue is recorded and recognized as an item in a company’s financial statements. Theoretically, there are multiple points in time at which revenue could be recognized by companies. Generally speaking, the earlier revenue is recognized, it is said to be more valuable to the company, yet a risk to reliability.

In accounting, revenue recognition is one of the areas that is most susceptible to manipulation and bias. In fact, it is estimated that a significant portion of all accounting fraud stems from revenue recognition issues, given the amount of judgment involved. Understanding the revenue recognition principle is important in analyzing financial statementsAnalysis of Financial StatementsHow to perform Analysis of Financial Statements. This guide will teach you to perform financial statement analysis of the income statement,.

Revenue Recognition Criteria

According to IFRS standardsIFRS StandardsIFRS standards are International Financial Reporting Standards (IFRS) that consist of a set of accounting rules that determine how transactions and other accounting events are required to be reported in financial statements. They are designed to maintain credibility and transparency in the financial world, all of the following five conditions must be met for a company to recognize revenue:

• There is a transfer of the risks and rewards of ownership.
• The seller loses continuing managerial involvement or control of the goods sold.
• The amount of revenue can be reasonably measured.
• Collection of payment is reasonably assured.
• The costs incurred can be reasonably measured.

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Revenue Recognition for the Sale of Goods

For the sale of goods, most of the time, revenue is recognized upon delivery. This is because, at the time of delivery, all five criteria are met. An example of this may include Whole Foods recognizing revenue upon the sale of groceries to customers.

Revenue recognition at delivery will look like this:

DR Cash or Accounts Receivable          a

CR Revenue                                                a

When revenue is recognized, according to the matching principle, expenses must also be considered for:

DR Cost of Goods Sold                         b

CR Inventory                                          b

Revenue Recognition Before and After Delivery

For the sale of goods, IFRS standards do not permit revenue recognition prior to delivery. IFRS does, however, permit revenue recognition after delivery.

There are situations when there are uncertainties regarding the costs associated with future costs, violating the fifth criteria for revenue recognition as outlined above.

For example, if a company cannot reliably estimate the future warranty costs on a specific product, the criteria are not met. When the fifth criterion is met, at that point revenue may be recognized.

Other reasons for revenue recognition after delivery include situations where the amount of revenue cannot be reasonably determined (e.g., contingent sales), inestimable returns, unassured collectability of accounts receivable, and risks of ownership remaining with the seller (consignment sales).

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Journal Entries for the Revenue Recognition Principle

Typical journal entries look like:

DR Cash

CR Deferred Revenue

DR Deferred COGS

CR Inventory

Instead of crediting revenue and debiting COGSCost of Goods Sold (COGS)Cost of Goods Sold (COGS) measures the “direct cost” incurred in the production of any goods or services. It includes material cost, direct, deferred revenue and deferred COGS are used. When revenue can be recognized, then these deferred accounts are closed to actual revenue and COGS:

DR Deferred Revenue

CR Revenue

DR COGS

CR Deferred COGS

Installment Sales Method and the Revenue Recognition Principle

Installment sales are quite common, where products are sold on a deferred payment plan and payments are received in the future after the goods have already been delivered to the customer. Under this method, revenue can only be recognized when the actual cash is collected from the customer.

Example:

In May, XYZ Company sold $300,000 worth of goods to customers on credit. In June, $90,000 was collected and in September, $210,000 was collected. The COGS is 80%.

Using the installment sales method, the journal entries would be:

May:

DR Instalment Accounts Receivable          300,000

CR Deferred Revenue                                  300,000

DR Deferred COGS                                       240,000

CR Inventory                                                  240,000

June:

DR Cash                                                          90,000

CR Instalment Accounts Receivable          90,000

DR Deferred Revenue                                  90,000

CR Sales Revenue                                         90,000

DR COGS                                                        72,000

CR Deferred COGS                                       72,000

September:

DR Cash                                                         210,000

CR Instalment Accounts Receivable          210,000

DR Deferred Revenue                                  210,000

CR Sales Revenue                                         210,000

DR COGS                                                        168,000

CR Deferred COGS                                       168,000

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Revenue Recognition Principle for the Provision of Services

One important area of the provision of services involves the accounting treatment of construction contracts. These are contracts dedicated to the construction of an asset or a combination of assets such as large ships, office buildings, and other projects that usually span multiple years.

In recognizing revenue for services provided over a long period of time, IFRS states that revenue should be recognized based on the progress towards completion, also referred to as the percentage of completion method.

These contracts are of two kinds: fixed price contracts and cost-plus contracts.

In fixed-price contracts, the contractor/builder agrees to a price before construction actually begins. Thus, all the risks are imposed on the contractor.

In cost-plus contracts, the price depends on the amount actually spent on the project plus a profit margin. For companies reporting under ASPE, the completed-contract method may also be used.

As opposed to the percentage of completion method, the completed contract method only allows revenue recognition when the contract is completed.

Additional Resources

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