Revenue recognition is a generally accepted accounting standard (GAAP) that identifies and accounts for the exact criteria under when and how revenue is to be recognised. When a significant event occurs, revenue is typically recorded, and the monetary amount is measurable for the organisation.
- A generally accepted accounting principle (GAAP) specifies how and when revenue should be recognised
- Revenues are recognised when they are realised and generated, not when cash is received, according to the revenue recognition concept of accrual accounting
- The ASC 606 revenue recognition standard establishes a consistent framework for reporting revenue from client contracts
This standard addresses the criteria for recognising revenue in a company’s profit and loss statement. The standard is concerned with the recognition of income deriving from:
- The sale of things
- The performance of services
- The use by others of enterprise resources earning interest, royalties, and dividends in the usual course of business
The following components of revenue recognition for which special considerations apply are not covered by this standard:
- Construction contracts generated revenue
- Hire-purchase and lease agreements generated revenue
- Government grants and other comparable subsidies generated revenue
- Insurance businesses generated revenue from insurance contracts
“Revenue is the gross inflow of cash, receivables, or other consideration arising in the course of an enterprise’s ordinary activities from the sale of goods, rendering of services, and from various other sources such as interest, royalties, and dividends,” according to the ICAI’s AS 9 Revenue Recognition.
Revenue Recognition Concept
All business performance is based on revenue. The sale determines everything. When whole revenue is not received at the end of the project, advocates, for example, bill their clients in billable hours and present an invoice once the job is accomplished. Clients are frequently billed on a percentage-of-completion basis by construction managers.
Revenue accounting is quite basic when a product is sold, and revenue is recognised when the customer pays for the goods. It becomes complex when a corporation takes a long time to develop a product. As a result, there are various scenarios in which the revenue recognition principle can be disregarded.
Therefore, analysts prefer that revenue recognition procedures for one business be consistent across the industry. When evaluating line items on the income statement, having a uniform revenue recognition rule helps to ensure that an apples-to-apples comparison can be made between organisations. In order to assess and review historical financials for seasonal trends or discrepancies, revenue recognition principles inside a corporation should also remain consistent over time.
Revenue Recognition Principle
According to the revenue recognition principle, income should only be recorded when it’s an earning and not a gift. For example, a snow ploughing service may complete the ploughing of a company’s parking lot for $100. Even if it does not expect payment from the customer for several weeks, it can record revenue immediately once the ploughing is completed. The accrual basis of accounting incorporates this concept.
When the same snow ploughing firm gets paid $1,000 in advance to shovel a customer’s parking lot over a four-month period, this is a variant on the case. To represent the rate at which it is earning the payment, the service should recognise an increment of the advance payment in each of the four months covered by the agreement.
Revenue can be recognised when all the following criteria are met:
- There is a credible indication that a deal has been made
- Goods have arrived or services have been rendered
- The buyer’s selling price or charge is fixed or can be established properly
- There is a reasonable chance that the seller’s payment will be collected
Revenue Recognition Methods
- Sales base Method
The sales base technique is a widely used revenue recognition accounting method. The revenue from a sale is recorded each time it is made. This is true for all transactions, including those in which the money isn’t made at the same time as the sale. Customers will occasionally pay in advance.
- Easy to use
- Accurate cash flow allows you to see how much cash you have on hand at any particular time
- Without a sophisticated accounting system, the one entry approach makes it simple to operate
- Complete-contract Method
After the entire contract is fulfilled, the completed-contract approach permits you to recognise income when all performance requirements have been met. For shorter contract periods, completed-contract is an effective way to guarantee that revenue is recorded in the relevant period on the financial statements. If you have a long-term return policy or offer prolonged warranty durations, this is not a good technique.
- Percentage of completion Method
The percentage of completion approach, commonly used with big or long-term contract agreements, allows organisations to collect revenue based on milestones or other progress indicators. This method necessitates a thorough contract that specifies each milestone or deliverable to determine revenue recognition.
Rather than waiting until the end of a long contract, the percentage of completion technique allows you to receive revenue sooner. Financial accounts demonstrate a more steady revenue stream with fewer significant spikes and a more predictable revenue stream.
- Instalment Method
Your consumers aren’t all able to pay in whole. Giving them other choices can help you build long-term relationships with them. They can use the instalment approach to spread out the total amount owing over a period of time. They will pay a certain amount each month until the bill is paid in full.
- Customers who would be unable to purchase from you are able to do so
- It helps to solve cash flow issues
- It increases the likelihood of repeat business from existing consumers
Understanding the benefits of each of these revenue recognition methods in accounting allows you to tailor how you register income and expenses for your company. The data ensures that you can see all the money in-flow, how much you’re spending on overhead, and how much money you’re making overall. It allows you to see where you excel and where you fall short. Avoiding cash flow problems is an essential element of running a successful business.