What is the Revenue Recognition Principle?

Most of the big companies do business on credit. They supply goods and services for which the payments are received at a later stage or over a period of time. Hence, it becomes important for companies to follow a standard process to recognize the revenue from such transactions and record them in their financial statements.

There are multiple stages at which a company can recognize the revenues in its books.

Revenue Recognition Criteria

According to the International Financial Reporting Standards, the following conditions must be satisfied to have a company recognize its revenues −

  • There should be sufficient assurance that the payment will be received. We use the term "sufficient" because companies cannot be 100% sure all the time; there will always be a risk of default in financial transactions.

  • The seller should be able to measure the costs incurred in providing the goods and services.

  • The seller should also be able to calculate the revenue that will be generated.

  • Once the goods are sold, the ownership lies with the buyer, even though the payment has not been released. Before a company recognizes the revenues, there must be a transfer of ownership for the goods sold. The seller loses continuing managerial involvement or control of the goods sold.

Generally, it is better for the company to recognize the revenues early and show it in their books because it projects a strong financial position; however, there is a risk of actually receiving the payment on time.

Revenue Recognition After Delivery

If we go by the rules set by IFRS, a company that sells its goods should recognize the revenues after the goods are delivered. This is because all the above criteria are satisfied at the time of delivery. IFRS standards do not allow revenue recognition prior to delivery, when the company sells its goods.

Following are some of the reasons why a company should opt for revenue recognition only after delivery −

  • When the goods are shipped over a consignment, the risk of ownership lies with the seller until the goods are delivered to the buyer.

  • The buyer may reject a consignment due to quality issues.

  • There may be a Return Clause in some cases and if the buyer is not satisfied with the product for some reason, they may return the products for which the seller will not receive any payments.

  • Sometimes it becomes difficult to estimate the future costs involved (for example, warranty and servicing costs) after the goods are sold.

In such cases, if the revenue is realized at an early stage before delivery of the goods, then it will obviously lead to erroneous results, should the goods are returned or rejected at the time of delivery.

Installment Sales

It is a type of revenue recognition method where the revenues and the expenses are recognized when the actual payment is received. The seller supplies the goods on a deferred payment plan and the buyer makes the payments in installments.

Revenue Recognition in Projects

There are companies that take bulky projects that may take several years to complete. For example, suppose Larsen and Toubro (an Indian construction company) is awarded the Metro Rail project in a city. Now, this sort of a project can span multiple years. In such cases, the company should recognize the revenues based on how much work has been completed so far and what is the progress towards completion.

Such long-term contracts can be divided into two categories −

  • Fixed-price contracts - In fixed-price contracts, the company that provides the service agrees to a price before the work actually starts. If the cost of raw material shoots up in the future, then the company is liable to bear all such risks.

  • Cost-plus contracts - In cost-plus contracts, the revenue is calculated based on the costs actually incurred in completing the project.

To conclude, it is extremely important to have a deep understanding of the revenue recognition principle while analyzing the financial statements of a company. Companies sometimes recognize the revenues early to project a rosy picture to their investors. Sometimes they opt for installment sales to defer their tax liability to the next fiscal year. Revenue Recognition is an area that is susceptible to all kinds of manipulation and most of the accounting frauds arise due to deliberate entry of incorrect data in the revenues generated section.