Revenue Recognition

Revenue Recognition

Introduction

The revenue recognition is a concept which is derived from the matching principle, i.e. matching expenses and revenues. The only way an investor can determine the true profitability of his investment is by comparing cash and cost of the business. However, GAAP (Generally Accepted Accounting Principles) provide multiple ways for recognizing revenue. Revenues have direct impact on income statement and all profitability ratios. Income affects the dividend payment. Therefore, sales value can have major effects on the investor behavior. According to SFAC 5, there are two main conditions which are required for revenue recognition.

Completion of the Earnings Process

Under this condition, the seller must complete his all obligations to the customer. For instance, if a buyer asked for 500 units of basketballs and seller has only delivered 450 units, the transaction is incomplete. Similarly, if seller is the manufacturer of refrigerators and provides 5 year warranty coverage, the revenue cannot be booked unless all costs are reasonably estimated.

Assurance of Payment

The company (seller) must be estimate probability of receiving payment.

Revenue Recognition through Sales Basis

This is the most understood method. The revenue is recognized when sale is executed, when the title of product is transferred to customer. The sale can also be a credit sale, which means that sales in not recognized even if the cash is paid before completion of transaction.

Percentage of Completion Method

Companies who undertake longer projects such as building bridges may require a long time before delivering the final product. During this time, the company would like to show income to its shareholders, although project may be incomplete. In such circumstances, the company would prefer percentage of completion method. There are two ways of recognizing revenues under this method.

Using targets such as distance of bridge completed

Cost incurred to estimated total cost

Cost Recoverability Method

This method is the most conservative method of all. This approach is used when a company is unable to estimate the total expense needed to finish the product. This would mean that no profit is recognized till all expenses have been recouped.

Installment Method

This method is generally used when company is unsure about actual cash collection. This method is commonly used in real estate transactions where cash collection is subject to high risk of buyer financial crisis. Gross profit is calculated as ratio to cash received.

It is apparent from the above discussion that company's management can easily manipulate its income statement by changing the recognition method. The income statement can be manipulated to show healthy income whereas; the actual condition of company might be dire. This is where investors are encouraged to contrast revenue recognition of 2 companies operating in a same industry to evaluate the true performance of both companies.

The Difference between a Product and Period Expense

Product expenses are those expenses which the company will require in incur when it will decide to manufacture a product. Examples include wage expense, cost of raw material and other.

On the other hand, period costs are incurred irrespective of whether company decides to manufacture or ...