Revenue Recognition Principle
Revenues are recognized
when
(a) realized or realizable
and
(b) earned.
[SFAC No. 5, Para. 83]
Revenues
--> not recognized until realized or realizable.
--> not recognized until earned.
Revenues are realized
--> when products are exchanged for cash or claims to cash.
Revenues are realizable
--> when related assets received are readily convertible
to cash or claims to cash.
Revenues are earned
--> when the products are delivered
or
--> services are performed.
Recognition is the process of
--> recording an item in the financial statements.
Realization is the process of
--> converting non-cash resources into cash.
Revenues are
--> inflows of assets or settlements of liabilities (or both)
--> from activities of the entity's central operations.
Gains are
--> increases in net assets
--> from peripheral or incidental transactions of an entity.
ARB No. 43, Chapter 1A
Accounting Research Bulleting (ARB) No. 43
a. Chapter 1A
b. Issued in June 1953
Unrealized Profit
--> should not be credited to income.
Profit is deemed to be realized
--> when a sale (in the ordinary course of business) is effected.
--> unless the collection of sale price is not reasonably assured.
Profit is NOT deemed to be realized
--> if the collection of sale price is not reasonably assured.
APB Opinion No. 10
Accounting Principles Board (APB) Opinion No. 10
a. Omnibus Opinion
b. Issued in December 1966
Revenues
--> should (ordinarily) be accounted for
--> at the time of a transaction is completed
--> with appropriate provision for uncollectible accounts.
[Para. 12]
Installment Method of Recognizing Revenue
--> is not acceptable, with the exception of cases
--> where receivables are collectible over an extended period of time
--> and there is no reasonable basis for estimating the degree of collectibility.
When the following conditions are met
--> either installment method
--> or cost recovery method may be used.
Conditions
--> receivables are collectible over an extended period of time
--> and there is no reasonable basis for estimating the degree of collectibility
Cost Recovery Method
--> equal amounts of revenue and expense are recognized
--> as collections are made
--> until all costs have been recovered.
--> recognition of profit is postponed until all costs are recovered.
SFAS No. 48
Statement of Financial Accounting Standards (SFAS) No. 48
a. Revenue Recognition When Right of Return Exists
b. Issued in June 1981
Sale that gives buyer the right to return the product
--> Revenue from such sales shall be recognized
--> at the time of sale
--> ONLY IF all of the following conditions are met.
Conditions
a. Seller's price
--> is substantially fixed or determinable at the date of sale.
b. Buyer's obligation to pay seller
--> is not contingent on resale of the product.
c. Buyer's obligation to pay seller
--> does not change when the product is lost or damaged.
d. Buyer acquiring the product for resale
--> has economic substance apart from that provided by seller.
e. Seller does not have significant obligations
--> for future performance to directly bring about
--> resale of the product by buyer.
f. Amount of future returns
---> can be reasonably estimated.
Revenues that are not recognized at the time of sale
--> because the above conditions are not met
--> shall be recognized
either
when the return privilege has substantially expired
or
when the above conditions are subsequently met
--> whichever occurs first.
Cost of returns
--> if sales revenue is recognized because the above conditions are met
--> any costs or losses expected due to any returns
--> shall be accrued as required by SFAS No. 5, Accounting for Contingencies.
Estimated returns
--> Sales revenue and cost of sales
--> shall be reduced to reflect estimated returns.
Examples of Revenues and Gains
Operating Revenues
Operating revenues include
--> revenue accounts generated from the primary operations of the company.
Sales
Nonoperating Revenues and Gains
Nonoperating revenues and gains include
--> revenue and gain accounts generated from
--> other than the primary operations of the company.
Interest revenue (or interest income)
Gain on sale of securities
Gain on sale of buildings
Gain on sale of machinery
Gain on sale of equipment
Interest revenue (or interest income) account
--> may be classified as operating revenues
--> for banks and other financial corporations
--> whose primary operations are lending money to earn interest income.
Gains from Discontinued Operations
Gains from discontinued operations are
--> due to the disposal of business segment.
Gain from operations of discontinued business segment
Gain on disposal of business segment
Extraordinary Gains
Extraordinary gains include
--> gains that unusual and infrequent.
Gain on early extinguishment of debt
Accrual Basis Accounting
Under the accrual basis accounting, revenues and expenses are recognized as follows:
Revenue recognition: Revenue is recognized when both of the following conditions are met:
a. Revenue is earned.
b. Revenue is realized or realizable.
Revenue is earned when products are delivered or services are provided.
Realized means cash is received.
Realizable means it is reasonable to expect that cash will be received in the future.
Expense recognition: Expense is recognized in the period in which related revenue is recognized (Matching Principle).
Cash Basis Accounting
Under the cash basis accounting, revenues and expenses are recognized as follows:
Revenue recognition: Revenue is recognized when cash is received.
Expense recognition: Expense is recognized when cash is paid.
Timing differences in recognizing revenues and expenses
There are potential timing differences in recognizing revenues and expenses between accrual basis and cash basis accounting.
Four types of timing differences
a. Accrued Revenue: Revenue is recognized before cash is received.
b. Accrued Expense: Expense is recognized before cash is paid.
c. Deferred Revenue: Revenue is recognized after cash is received.
d. Deferred Expense: Expense is recognized after cash is paid.
An Example of Accrued Revenue
Example: Products are sold at $5,000 on May 1, 2006 and cash is received on May 10, 2006.
May 1, 2006
May 10, 2006
Revenue is recognized.
Cash is received.
[Journal entry on May 1, 2006]
Debit
Credit
Accounts receivable 5,000
Sales 5,000
[Journal entry on May 10, 2006]
Debit
Credit
Cash 5,000
Accounts receivable 5,000
An Example of Accrued Expense
Example: On May 1, 2006, Company A borrowed $100,000 from a bank and promised to pay 12% interest at the end of each quarter.
May 31, 2006
June 30, 2006
Interest expense is recognized for May.
Cash is paid at the end of the quarter.
[Journal entry on May 1, 2006]
Debit
Credit
Cash 100,000
Borrowings from bank 100,000
[Journal entry on May 31, 2006]
Debit
Credit
Interest expense 1,000
Interest payable 1,000
$100,000 x 12% x 1/12 = $1,000 for each month.
Interest payable is a liability account.
Credit side of interest payable (a liability account) represents an increase.
[Journal entry on June 30, 2006]
Debit
Credit
Interest expense 1,000
Interest payable 1,000
Credit side of interest payable (a liability account) represents an increase.
Debit
Credit
Interest payable 2,000
Cash 2,000
Company pays $2,000 as interests for May and June.
Debit side of interest payable (a liability account) represents a decrease.
An Example of Deferred Revenue
Example: On May 1, 2006, Company A had a new lease contract with a tenant and received $6,000 for two month rent.
May 1, 2006
May 31 and June 30 2006
Cash is received.
Revenue is recognized at the end of May and June.
Revenue is recognized when Company A provides service. In this example, service is provided when time passes.
[Journal entry on May 1, 2006]
Debit
Credit
Cash 3,000
Unearned rent revenue 3,000
Unearned rent revenue is a liability account.
Credit side of unearned rent revenue (a liability account) represents an increase.
"Unearned revenue" accounts represent the amount of cash received before services are provided. Since services have not been provided yet, it is not revenue.
"Unearned revenue" accounts are liabilities of the company, because they should be paid back to the other party if service is not provided in the future.
[Journal entry on May 31, 2006]
Debit
Credit
Unearned rent revenue 3,000
Rent revenue 3,000
Debit side of unearned rent revenue (a liability account) represents a decrease.
Credit side of rent revenue (a revenue account) represents an increase.
[Journal entry on June 30, 2006]
Debit
Credit
Unearned rent revenue 3,000
Rent revenue 3,000
Debit side of unearned rent revenue (a liability account) represents a decrease.
Credit side of rent revenue (a revenue account) represents an increase.
An Example of Deferred Expense
Example: Company A purchased an insurance for a period from May 1, 2006 to July 31, 2006 and paid $6,000 cash for three month insurance premium.
May 1, 2006
May 31, June 30, July 31, 2006
Cash is paid.
Expense is recognized at the end of May, June and July.
[Journal entry on May 1, 2006]
Debit
Credit
Prepaid insurance 6,000
Cash 6,000
Prepaid insurance is an asset account.
Debit side of prepaid insurance (an asset account) represents an increase.
[Journal entry on May 31, 2006]
Debit
Credit
Insurance expense 2,000
Prepaid insurance 2,000
Credit side of prepaid insurance (an asset account) represents a decrease.
[Journal entry on June 30, 2006]
Debit
Credit
Insurance expense 2,000
Prepaid insurance 2,000
Credit side of prepaid insurance (an asset account) represents a decrease.
[Journal entry on July 31, 2006]
Debit
Credit
Insurance expense 2,000
Prepaid insurance 2,000
Credit side of prepaid insurance (an asset account) represents a decrease
CAclubindia
