The revenue recognition principle is the basis for recording revenues in accounting. Why is the revenue recognition principle needed in accounting? Let’s find out!
Revenue Recognition Principle Explained?
Revenue cannot be reported when a company wants. There has to be a reporting standard.
If a company records revenue too soon, its income statement may show more profit than was actually made in that time period. This will cause their financial statement for future time periods to have less profitability. Incorrectly reported income causes ripples that impact the current and following year’s tax returns.
The accounting principle of recognizing revenues requires revenues to be recorded only when they have been earned by a company. So, why is the revenue recognition principle needed? Continue reading to find out!
Revenues or incomes should be recognized as services or products are rendered, not when payment is made.
The revenue recognition principle states that companies can record income from sales as soon as the products or services are delivered to customers, regardless of when payment is received. This accounting method is called accrual basis accounting and it provides a more accurate picture of a company’s financial position.
Why is the Revenue Recognition Principle Needed?
Proper revenue recognition is essential because it directly affects the integrity of a company’s financial reporting. The guidance on revenue recognition is intended to standardize revenue policies across companies. Revenue standardization allows investors and analysts to compare income statements from different companies within the same industry.
Investors use the revenue to evaluate a company’s performance. Therefore, it is important that financial statements are consistent and credible.
The revenue-recognition principles in companies are fuzzy and unclear.
The rules of “Revenue Recognition” in corporate bookkeeping are ambiguous and unclear. This has resulted in many corporations being confused as to when they should recognize income. Some firms have resorted to using “creative” methods to take advantage of these gray areas. Attorneys need to be wary of these tactics, as they may inadvertently be implicated in questionable behavior.
The new accounting standards, known as International Financial Reporting Standards (IFRS) 15, which took effect in 2018, require companies to be more transparent and disclose more information.
One problem with recognizing revenue for long-term agreements is when the agreement is for a year or more. For instance, if a company agrees to complete a building project over 18 months for a fixed fee, it must recognize all the income from the project upfront.
There are two main options for how a contractor can account for revenue from a multi-year contract. They can either split all the revenue and expenses evenly across the years, or they can wait until the entire project is completed before accounting for any of the money. Each method has its own pros and cons that need to be considered before a decision can be made.
These variables make it hard to determine when exactly you should record revenue from a call, and by how much.
In both of these situations, it is common practice for an accountant to record the revenue from the project, regardless of whether the business has actually received any payment.
However, it should also be noted that, with the amount of discretion and judgment these circumstances allow, there’s room to game the accounting process.
Multiple component transactions
The second most common area of confusion in recognizing revenue is for companies that offer a mix of products and services. A good example is a tech company that provides a bundle of services, including:
This can create a lot of confusion for a company. A tech company providing multiple products, including hardware and software, along with services, support, and warranty, may find it challenging to determine when to recognize revenue and which products are driving that.
As these products or services often depend on each other, it can be complicated to separate the revenue and measure it over time.
Companies are solving the issue of multiple component sales by delaying a portion of revenue on each sale. This takes into consideration the rate of returns, and at what stage in the warranty they are sent back. Doing this changes the revenue and profit numbers, but gives a better picture of a company’s financials.
This is a great way because it allows you to report revenue and profits, which are two metrics that financial analysts closely watch.
In order to make accurate assumptions about the likely success of a product or service, it’s important to have a track record in sales.
This can make it hard to identify revenue from new products or services that don’t have a historical record of selling.
The year-end cut-off, “Team and Load” or “channel-stuffing”
This final point of disagreement is about short-term revenue growth.
If companies are allowed to report revenue from the products they deliver, they can artificially boost their earnings by reporting more sales than they actually deliver. This is called “channel-stuffing” or “trade-loading”.
Channel-stuffing, or “trade-loading,” is a practice where companies buy more inventory than they need, then sell it at a cheaper price.
A channel-stuffing scheme is one in which companies ship extra inventory to distributors or retailers at the end of their fiscal year, regardless of whether the distributor or retailer has actually asked for it. The practice involves offering discounts and incentives for the merchandise, such as extending credit and taking a loss on the returned items. The sales are recorded as revenue and profits on the company’s financial statements.
A tell-tale sign that a company is engaging in channel-stuffing is if many of its products are being returned by customers soon after the beginning of a new fiscal quarter.
Another sign that a buyer is interested is when they want the contract to take effect when the delivery will take place, when the service will be rendered, or when the goods are accepted.
To be a little different. This is occasionally suggestive of the parties wanting to record the transaction in their separate accounts, for example,
The buyer and seller have conflicting timelines. The buyer wants to purchase the product now, but the seller has no budget until the year after.
New rules for accounting
With business becoming more complex, and new regulations constantly being put in place, accountants have been trying their best to reduce the room for accounting errors.
The International Financial Reporting Standard 15 (IFRS 15) is a new financial reporting standard for revenue recognition.
This will force companies around the world to follow the same accounting rules when it comes to how they recognize revenue and disclose their financials.
The new standards require companies to follow one basic rule for all their customer contracts. This rule is based on a five-step process:
These 5 steps are:
1. Identifying the contract with a client.
2. Determining all the separate promises in the agreement.
3. Calculating the agreed price for these promises.
4. Allocating that cost to each individual promise.
5. Recognizing the revenue from fulfilling each obligation.
GAAP Principles for Revenue Recognition
GAAP accounting principles are created using guidance from the FASB. The FASB ASC 606 outlines the revenue recognition principle, which is a key feature in accrual-basis accounting. It is therefore an integral GAAP principle. It states:
Topic 606’s core principle is that revenue should be recognized to show the transfer of goods and services to customers in an amount that represents the consideration that the entity expects that it will receive in return for those goods and services.
This principle ensures that companies complying with GAAP recognize their revenue only when the service or product is delivered to customers, and not when cash is received.
This principle aside, the U.S. GAAP guidance before it was published was extremely complicated. There were many inconsistent requirements for how to recognize revenue. These requirements varied greatly between industries and geographies.
The FASB released the update to ASC 606, which replaced GAAP’s 100 different transaction-specific guidelines with a simple, five-step framework. It provides more information about revenue recognition in contractual situations, and a framework that is industry-neutral to improve the comparability of financial statements.
The IASB quickly followed suit and issued IFRS 15 Revenue from Contracts With Customers. These accounting standards have essentially achieved convergence of the U.S. GAAP with the IFRS with some minor differences.
Revenue recognition is an important concept for companies of all sizes, public and private. Businesses must look at revenue recognition policies strategically to ensure that they are in compliance now and are compatible with future filings, expansion goals, and financing.
Advanced financial management software can help you plan, calculate, and present revenue on your financial reports accurately. It will automate revenue forecasting, allocations, recognition, reclassification, and auditing through a rule-based event handling framework. This software is applicable to sales transactions that are products or services and whether they occur at one point in time or over multiple milestones.
So, why is the revenue recognition principle needed? The revenue recognition principle is essential to understanding how businesses record their sales and income. Without it, businesses would have no way of knowing when to properly record their revenue. This principle provides a consistent framework that all businesses can use to ensure that they are recording their revenues correctly.