Principles of Revenue Recognition and Accrual Accounting

Revenue is reported on the top line of the income statement. Accrual accounting allows revenue to be recognized, i.e., reported on the income statement when it is earned, and not necessarily when cash is received.

Companies disclose their revenue recognition policies in the notes to their financial statements. It is useful to review these policies to understand how and when a company recognizes revenue, especially when making comparisons with other companies.

General Principles of Revenue Recognition

According to IFRS, a company should recognize revenue from the sale of goods whenever the following conditions are satisfied:

• the company has transferred the significant risks and rewards of ownership of the goods to the buyer;
• the company neither retains effective control over the goods sold nor continues to exercise management over the goods to the same degree associated with ownership;
• revenue can be reliably measured;
• the economic benefits that are associated with the transaction will probably flow to the company; and
• transaction costs incurred or to be incurred can be reliably measured.

IFRS also specifies similar criteria for recognizing revenue from the services rendered once the outcomes of the transactions can be reliably estimated. Revenue will be recognized by reference to the stage of completion of the transaction as at the balance sheet date. The outcome of the transaction may be reliably estimated when all the following conditions have been satisfied:

• revenue can be reliably measured;
• the economic benefits associated with the transaction will probably flow to the company;
• at the balance sheet date, the stage of completion of the transaction can be reliably measured; and
• the transaction costs incurred and the costs to complete the transaction can be reliably measured.

IFRS recognizes interest, royalties, and dividends when it is probable that the economic benefits associated with a transaction will flow to a company and the revenue can be reliably measured.

According to US GAAP, revenue is recognized when it is “realized or realizable and earned”. The guidance provided by US GAAP lists four criteria to determine when revenue is realized or realizable and earned:

• evidence exists of an arrangement between the buyer and seller;
• a product has been delivered, or a service rendered;
• price is determined, or determinable; and
• there is reasonable assurance that the seller will collect money.

Specific Revenue Recognition Applications

In some instances, revenue recognition is more difficult to determine than it appears to be based on the general principles outlined. This is especially the case whenever revenue is recognized before or after goods are delivered or services rendered. This is the case for long-term contracts, installment sales, and barter.

Long-term Contracts

Long-term contracts span several accounting periods and present challenges concerning when the earning process has been completed and revenue recognition should therefore occur.

Installment Sales

Installment sales are sales in which proceeds are to be paid in installments over an extended period of time. IFRS separates the installments into the sale price, which is the discounted present value of the installment payments, and an interest component. The revenue which is attributable to the sale price is recognized at the date of sale, and revenue attributable to the interest component is recognized over time.

Barters

Under IFRS, revenue from barter transactions must be measured based on the fair value of revenue derived from similar non-barter transactions with unrelated parties.  US GAAP, on the other hand, states that revenue can be recognized at fair value only if a company has historically received cash payments for such services and can, therefore, use this historical experience as a basis for determining fair value. Otherwise, the revenue should be recorded at the carrying amount of the asset surrendered.

Gross versus Net Reporting

US GAAP regulates the gross versus net reporting of revenue. Precisely, US GAAP determines when revenue should either be reported on a gross or net basis. Before revenue is reported on a gross basis, US GAAP states that it should be established that the company: (i) is the primary obligor under the contract; (ii) bears credit risk and inventory risk; (iii) can choose its supplier; and (iv) has reasonable latitude to establish prices. 

If these criteria are not met, the company should report net revenues.

Financial Analysis Implications

When conducting a financial analysis on a company’s financial statements, it is important to note whether the company’s revenue recognition policy results in the recognition of revenue sooner rather than later. In addition, it is equally important to pay attention to the extent to which the policy requires the company to make estimates.

It is also important to understand any differences in the revenue recognition policies when comparing one company’s financial statements with those of another. This makes it possible to characterize the relative conservatism of a company’s revenue recognition policy. Besides, it facilitates quantitative assessment of how differences in policies might affect financial ratios.

Question

According to IFRS, which of the following conditions must be satisfied in order for a company to recognize revenue derived from the sale of goods?

1. Revenue from the transaction cannot be measured reliably.
2. It is probable that the economic benefits associated with the transaction will flow to the company.
3. The significant risks and rewards of ownership of the goods have been transferred from the buyer to the seller.

Solution

The correct answer is B.

For revenue derived from sale of goods to be recognized, it has to be probable that the economic benefits that are associated with the transaction will flow to the company.

A is incorrect because another condition to be satisfied is for revenue to be reliably measured. 

C is incorrect because the condition should read that the significant risks and rewards of ownership of the goods are transferred from the seller to the buyer, not from the buyer to the seller.