Financial Accounting

(PGDM- 2015-16)

Session -12: Revenue Recognition

 Revenue Recognition -Introduction

• Accrual Concept of Accounting

• Revenue Recognition – When and How Much

• Normal Operating Cycle

• Revenue is recognized at a single point in the Cycle

• Objectivity- Not influenced by personal bias/ judgment;

verifiable, reliable.
 Revenue Recognition -Introduction

• Revenues are inflows or other enhancements of assets of

an entity or settlement of its Liabilities (or both) from
delivering or producing goods, rendering services or
other activities that constitute the entity’s ongoing major
or central operations (FASB Concept Statement 6)

• Expenses are outflows or other using up of assets or

incurrence of Liabilities (or both) from delivering or
producing goods, rendering services or other activities
that constitute the entity’s ongoing major or central
operations (FASB Concept Statement 6)
 Revenue Recognition -Introduction
• Characteristics of Revenues:
– Revenues represent actual or expected cash inflows
– The assets increased by revenue can be of various kinds – cash, claims,
other goods /services received, increased value of a product resulting
from production
– Transactions can be of different kinds – output, delivery, fee, interest,
dividend, rent, etc.

• Characteristics of Expenses:
– Expenses represent actual or expected cash outflows
– The liabilities incurred can be of various kinds – units of products
delivered/ produced, employees services used, electricity used, taxes
on income, etc.
– Transactions can be of different kinds – cost of goods sold, cost of
services provided, depreciation, interest, rent, etc.
 Timing of Revenue Recognition

• Revenue Recognition Criteria:

– Entity has substantially performed the income earning activities
– The amount of Income can be reliably measured
– The assets received can be readily converted into cash

• Since inappropriate revenue recognition has been found

in most of the financial frauds, SEC suggests that
Revenue should be earned and realized when: (SAB 101)
– Persuasive evidence of an order arrangement exists;
– Delivery of goods occurred/services rendered
– The seller’s price to the buyer is fixed or determinable
– Collectability of the sales proceeds is reasonably assured
 Timing of Revenue Recognition
• Methods of Revenue Recognition:
• Delivery Method – Revenue is recognized in the period when
goods are delivered or when services are rendered
– If certain, the income may be recognized after delivery
– If uncertain, income is recognized proportionately or only after
receiving the complete payment

• Consignment Shipments- The consignor retains the title of the

goods until they are sold. Hence, mere transfer of goods
should not be treated for revenue recognition

• Franchises: Revenue is to be recognized by Franchisors when

services is provided rather than when fee is received
 Timing of Revenue Recognition
• Percentage-of-Completion Method – Long term projects
take several years to complete. Hence, in such cases
revenue is recognized differently:
– Payment of predetermined amounts at certain periods of time
– Through a predetermined formula which includes cost+ profit

• When there is reasonable certainty of getting payments,

revenue can be recognized as per the percentage of work
that has been completed. Income is recognized similarly

• When the profit to be earned can not be estimated

reliably, revenue must be recognized when the project has
been completed
 Timing of Revenue Recognition
Percentage-of-Completion Method – Main advantages are:
– Periodic Income is recognized currently rather than at the
completion of the contract
– Status of incomplete projects is made clear through the current
estimates of cost to complete it.

• Success of Percentage-of-Completion Method lies in the

reliable estimation of ultimate costs. In order to accrue
income, it is necessary. However, future related
uncertainties make such estimation difficult

• Cash flows (payments) might be irrelevant in determining

the amount of revenue recognized during each period
 Timing of Revenue Recognition

• Production Method – For agriculture produce subjected to

MSP, revenue can reliably be recognized when the crops
are harvested

• For precious metals like gold and silver, revenue can be

recognized as soon as they are produced (unearthed), even
before being sold

• However, during periods of large sales price fluctuations,

production method might not give proper figures
 Timing of Revenue Recognition

• Installment Method – When sales are made on installment

basis, if the payments are high on reliability, revenue may
be recognized at the time sale is made

• If the amount of income to be realized cannot be

measured reliably, revenue is recognized when all the
installment payments are received

• Cost Recovery Method – In this method, the amount of

cost of sales is equated with the amount of installment
payments. Any excess is reported as income