Revenue Recognition Principle

Revenue recognition principle requires that a company must recognize revenue only when the goods or services are transferred to the customer and not when the associated cash flows occur.

Recently, accounting for revenue has undergone significant changes as a result of IASB and FASB attempting to converge revenue recognition under IFRS and US GAAP. The converged standards require a five-step process for revenue recognition. This involves:

  • Identifying a contract with a customer.
  • Identifying the performance obligations contained in each contract.
  • Determining the transaction price, the total consideration in the contract.
  • Allocating the transaction price to the performance obligations.
  • Recognizing revenue as and when each performance obligation is satisfied.

Following the aforementioned process often results in recognition of revenue proportionate to the goods delivered and/or services performed.

Revenue recognition principle is related to the accrual concept and matching concept because it results in recognition of revenue only to the extent of activities performed.

Examples

  1. A telecommunication company sells a hybrid (voice and data bundle) for US$50 which is prepaid. It does not recognize revenue when it receives the payment. It first allocates the transaction price to the voice component and the data component and recognizes revenue as the subscriber consumes talk time and uses data.
  2. A monthly magazine receives 1,000 subscriptions of $240 to be paid at the beginning of the year. Each month it recognizes revenue worth $20,000 [($240 ÷ 12) × 1,000].
  3. A media company recognizes revenue when the ads are aired even if the payment is not received or where payment is received in advance.

Where payments are received before goods and/or services are transferred, a company recognizes the receipt of cash by debiting cash and cash equivalents and crediting unearned revenue. However, if goods or services are transferred before payment is received, the company recognizes accounts receivable and credits revenue.

It is important for preparers of financial statements to exercise their judgement cautiously when recognizing revenue because it is the accounting area most prone to misstatements.

by Obaidullah Jan, ACA, CFA and last modified on
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