Revenue Recognition Principle

Introduction

It is one of the important accounting principles and is the basis of many accounting requirements set out in either of generally accepted accounting principles (GAAP) or alternatively International financial reporting standards (IFRS). The primitive requirement of the principle is that following the accrual concept in relation to the accounting of the transactions, Revenue should only qualify for recognition when there is substantial evidence with regard to the completion of the revenue cycle. Stated differently, record the revenue transaction, when there is reliable evidence that it is earned.

Example of the Revenue Recognition Principle

ABC is an organization that principally deals in relation to the snow plowing services. The company has completed the services in relation to the plowing of XYZ organization’s parking space. The standard charges for the service are $100. The revenue transaction can be recorded right after the rendering of the services of the plowing, though there is no expectation with regard to the payment from the intended customer for several further weeks. This is how revenue recognition principle functions under the accrual basis of accounting.

Revenue Recognition Principle and advance payment

Suppose that the XYZ organization pays $1,000 in advance in relation to the acquisition of the snow plowing services for the subsequent six months. In such case, there will be a recording of the incremental revenue in each month for which services are rendered. In this case, each month $166 amount of the revenue is recognized and an adjusting entry is passed to bring down the balance of the advance payment. In this way, revenue is accurately reflected for the entire period of the agreement that is six months in the subject case. The advance payment that is $1000 is not revenue for the ABC organization but a liability which will be settled down by the rendering of the services. This is why it is classified as current liability section in the Balance sheet unless it is completely set off by the corresponding adjusting entries to the revenue account.

Revenue Recognition Principle and Cash basis of Accounting

Revenue recognition principle is quite simple when the organization used the cash basis of accounting for the preparation of its financial statements. Cash basis of accounting requires that the organization should recognize revenue right at the point of receiving the payment irrespective of the fact that it relates to the service rendered in the prior periods or will be rendered in the future period(s).

Revenue Recognition Principle and IFRS

Revenue recognition is an important aspect of the financial reporting process of the organization. This is why it is subjected to excessive controls, so that risk of fraudulent financial reporting in revenue cycle is minimized. Over and above, Auditors also deem it as a risky area of the financial statements which may consist of misstatements. This is why Auditors apply extensive procedures on the Revenue to verify it. IFRS has also strongly emphasized the fair recording of the revenue and for this purpose issued a dedicated revenue standard to achieve the objective of fairness of revenue reporting.

Conclusion

The primitive requirement of the principle is that following the accrual concept in relation to the accounting of the transactions, Revenue should only qualify for recognition when there is substantial evidence with regard to the completion of the revenue cycle. Revenue recognition is an important aspect of the financial reporting process of the organization. This is why it is subjected to excessive controls, so that risk of fraudulent financial reporting in revenue cycle is minimized.