7 Important Criterion for Revenue Recognition

The following points highlight the seven important criterion for revenue recognition. Some of the criterion are: 1. Revenue Recognised at the Point of Sale 2. Revenue Recognition in Sale of Services 3. Revenue Recognition in Construction Work 4. Revenue Recognition in Instalment Credit Sales 5. Revenue Recognition Using Production Method and Others.

Criteria # 1. Revenue Recognised at the Point of Sale:

With limited exceptions, revenue is recognised at the point of sale. Generally Accepted Accounting Principles, require the recognition of revenue in the accounting period in which the sale occurs. Throughout the operating cycle, the business enterprise works forward the eventual sale of the goods and collection of the sales price. The enterprise’s earning process should be substantially complete before revenue is recorded.

Also, the revenue should be realised before it is recorded in the accounts. Realised means the goods or services are exchanged for cash or claims to cash. It is at the point of sale, then that the two important conditions for revenue recognition are met—at that time the revenue is both earned and realised.

Revenue for goods is not recognised when a firm receives sales order. Even though in some businesses the amount of income that will be earned can be reliably estimated at that time, there is no performance until the goods have been sold. A key point for determining when to recognise revenues from a transaction involving the sale of goods is that the seller has transferred the property in the goods to the buyer for a price.

The transfer of property in goods, in most cases, results in or coincides with the transfer of significant risk and rewards of ownership to the buyer. However, there may be situations where transfer of property in goods does not coincide with the transfer of significant risk and rewards of ownership.

Revenue in such situation is recognised at the time of transfer of significant risk and rewards of ownership to the buyer. Such cases may arise where delivery has been delayed through the fault of either the buyer or the seller and the goods are at the risk of the party at fault as regards any loss which might not have occurred but for such fault. Further, sometimes, the parties may agree that the risk will pass at a time different from the time when ownership passes.

Criteria # 2. Revenue Recognition in Sale of Services:

In transaction involving sale or rendering of services, revenues are usually recognised as the services are performed. For services, providing the service is the act of performance. For example, a real estate broker should record sale commission or brokerages as revenues when the real estate transaction is consummated. Revenues from renting hotel rooms are recognised each day the room is rented.

Revenues from maintenance contracts are recognised in each month covered by the contract. Revenues from repairing an automobile will be recognised when the repairs have been fully completed. In the repair of automobile, revenues are not recognised in case of partial repairs, because the service is to provide a completed repair job.

Criteria # 3. Revenue Recognition in Construction Work:

Some transactions may involve long term constructions and projects that may extend over several years. Examples are construction of roads, dams, large office buildings, bridges, ships, aircrafts, etc. In all such projects, the customer usually provides the product or project specifications.

The long term construction contract has provisions for predetermined amounts the customer must pay at different points and stages of work or suggest a formula that will determine customer payments within the actual project costs plus a reasonable profit.

In construction projects, revenues are recognised by the:

(i) Percentage-completion method or

(ii) Completed Contract method.

(i) Percentage-Completion Method:

The percentage-completion method simply allocates the estimated total gross profit on contract among the several accounting periods involved in proportion to the estimated percentage of the contract completed each period. To use this method we must have a reasonably accurate and reliable procedure for estimating periodic progress on the contract.

Most often, estimates of the percentage of contract completion are tied to the proportion of total costs incurred. If the income earned by the work done in the period can be reliably estimated, then revenue is appropriately recognised in each such period.

This method of revenue recognition is called the percentage-completion method because the amount of revenue is related to the percentage of the total project work that was performed in the period.

The percentage-completion method has four basic characteristics:

(а) Costs are accumulated separately for each distinct work project, contract or job order; each of these may be referred to as a job.

(b) The ratio of the amount of work done on each job to the total amount of work required by that job is estimated at the end of each period.

(c) Revenue from each job is recognised in proportion to progress on the job, as measured by the ratio of the work done to total work required.

(d) Job costs are recognised as expenses as revenues are recognised.

The percentage-completion method is most often used when the production cycle is long, the work is done under contracts with specific clients or customers, and adequate data on progress are available.

The contracts provide a basis on which to estimate the amount of cash to be collected after all production work has been completed; if the progress percentage data are valid, they provide assurance that the work done to date is readily measurable, the revenue recognition criteria are satisfied at the time of production as long as reliable progress percentage data are available.

The percentage-completion method recognises net revenue (profit) prior to realisation. It is sanctioned in order to permit the reporting of profit on a yearly basis by those entities involved in long-term construction projects. It is significant to note that the matching process normally entails first identifying revenues of a given period and then matching certain costs against them to obtain net income or profit.

That is, revenues are identified as the independent variable and costs, the dependent. But the percentage-completion method reverses the procedure by identifying the costs incurred in a given period as the independent variable and then matching future revenue to them.

Income Effects of Percentage-Completion Method:

Percentage—completion method has two effects. First, it leads to earlier recognition of revenue. Investors and external users may be informed more promptly of changes in volume of business activity or in the profit rate.

Second, this method is likely to report smoother income stream in long-cycle operations. Income smoothing is said to occur when a business enterprise selects from among acceptable alternative accounting methods to achieve income results that are relatively stable (i.e., smooth) over time.

(ii) Completed Contract Method:

Performance consists of the execution of a single act. Alternatively services are performed in more than a single act, and the services yet to be performed are so significant in relation to the transaction taken as a whole that performance cannot be deemed to have been completed until the execution of those acts.

The completed contract method is relevant to those patterns of performance and accordingly revenue is recognised when the sole or final act takes place and the service becomes chargeable.

As an alternative to percentage-completion method, the completed contract method may be used to account for long-term construction projects. This method recognises revenues upon final approval of the project by the customer, i.e., in effect at delivery.

The completed contract method would be suitable for an entity engaged in many long term projects some of which are completed each year. It should also be used in reference to the percentage-completion method in cases in which reasonable estimates of future costs cannot be done.

Under the completed contract method cost incurred on a project are treated as assets and held in an asset account (Work in Progress Account) till the period in which revenue is recognised. An example in taken here to illustrate the percentage-completion method and completed contract method.

Assure the following data about a contract to be completed within three years:

In the above example, 20 per cent, 50 per cent and 30 per cent of the project work was completed in the years 2006, 2007 and 2008 respectively.

Revenues for different years under the percentage-completion method has been calculated taking into account total contract price or project revenue and percentage of work performed each year, shown as follows:

Revenue:

Total contract price x percentage of work completed.

2006: 4,50,000 x 20% = Rs. 90,000

2007: 4,50,000 x 50% = Rs. 2,25,000

2008: 4,50,000 x 30% = Rs. 1,35,000

It can be noticed that both the methods report the same total income over the entire three-year period. But, in percentage-completion method, the total income Rs. 4,50,000 is allocated to each of the three years-2006, Rs. 90,000; 2007, Rs. 2,25,000; 2008, Rs. 1,35,000. Also the total payments received from the customer each year do not become revenue and are not relevant as well in determining the amount of revenue recognised each year under the two methods.

Criterion # 4. Revenue Recognition in Instalment Credit Sales:

Many business and merchandising firms sell goods on instalment basis wherein the customer pays a certain amount as instalment on the dates of instalment. In instalment sales revenue is not recognised at the point of sale.

The reason is that the amount of income cannot reliably measured at the point of sale if customers do not pay the future instalments. Therefore, in this case, revenue is recognised when the instalment payments are received.

Under the instalment method, the instalment payment received is considered as revenue and a proportionate part of the cost of sales becomes costs in the same period. The cost of the product is allocated by the ratio, cash collected during the period provided by total sales price (total cash expected).

A more conservative view is sometimes taken for recognising revenue in the instalment method, which is known as the cost recovery method. In the cost recovery method, all cash collections until all costs are recovered are mere return of costs of product.

Therefore, no income is reported until the instalment payments have recovered the total costs of sales; thereafter any additional cash received is income. The instalment method is more popular than the cost recovery method.

The instalment method indicates a conservative picture on revenue recognition; because the sale of the product does not constitute sufficient evidence that revenue has been earned.

Only the actual receipt of cash from the customer will provide the evidence required for revenue recognition. Thus, in the instalment method, revenue realisation precedes revenue (profit) recognition. That is, first instalment money is to be received before it is to be recognised as revenue.

Criteria # 5. Revenue Recognition Using Production Method:

In some cases, the amount of income that can be earned can be reliably measured as soon as the production is over. For instance, in case of certain grains and other crops, the government announces the price at which the farmers can sell their products. In such cases, although no sales has taken place, revenue can be reliably estimated at the point when the crops have been harvested. Therefore, revenue can also be recognised at the time of harvest.

The ICAI (India) in its Accounting Standard No. 9, states:

“At certain stages in specific industries, such as when agricultural crops have been harvested or mineral ores have been extracted, performance may be substantially complete prior to the execution of the transaction generating revenue. In such cases, when sale is assured under forward contract or a government guarantee or where market exists and there is a negligible risk of failure to sell, the goods involved are often valued at net realisable value. Such amounts while not revenue, are sometimes recognised in the statement of profit and loss and appropriately described.”

Criteria # 6. Revenue Recognition when a Firm Receives Interest, Royalties and Dividends:

A firm may allow others to use its resources and thereby can receive:

(i) Interest

(ii) Royalties and

(iii) Dividends.

(a) Interest are charges for the use of cash resources or amounts due to the enterprises;

(b) Royalties are charges for the use of such assets as know-how, patents, trade-marks and copyrights;

(c) Dividends are rewards from the holding of investments in shares.

Interest accrues, in most circumstances, on the time basis determined by the amount outstanding and the rate applicable. Usually, discount or premium on debt securities held is treated as though it were accruing over the period to maturity.

Royalties accrue in accordance with the terms of the relevant agreement and are usually recognised on that basis unless, having regard to the substance of the transactions, it is more appropriate to recognise revenue on some other systematic and rational basis.

Dividends from investments in shares are not recognised in the statement of profit and loss until a right to receive payment is established. When interest, royalties and dividends from foreign countries require exchange permission and uncertainty in remittance is anticipated, revenue recognition may need to be postponed.

Criteria # 7. Money Received or Amounts Paid in Advance:

Sometimes money is received or amounts are billed in advance of the delivery of goods or rendering of services, i.e., before revenue is to be recognised, e.g., rents or amount of magazine subscriptions received in advance. Such items are rightly not treated as revenue of the period in which they are received but as revenue of the future period or periods in which they are earned.

These amounts are carried as ‘unearned revenue’, i.e., liabilities, until the earning process is complete. In the future periods when these amounts are recognised as revenues, it results in recording a decrease in a liability rather than an increase in an asset.