Wednesday, July 15, 2009

When to Recognize Revenue ?

Revenue is recognized when it is probable that future economic benefits will flow to the entity and these benefits can be measured reliably” (IAS 18 Revenue).

Revenue can take various forms, such as sales of goods, provision of services, royalty fees, franchise fees, management fees, dividends, interest, subscriptions, and so on.

The principle issue in the recognition of revenue is its timing – at what point is it probable that future economic benefit will flow to the entity and can the benefit be measured reliably.

Some of the recent highly publicized financial scandals that caused turmoil in the financial world globally were allegedly the result of financial manipulations resulting from recognizing revenue based on inappropriate accounting policies. Such financial shenanigans resulting from the use of aggressive revenue recognition policies have drawn the attention of the accounting world to the importance of accounting for revenue.

It is absolutely critical that the point of recognition of revenue is properly determined. For instance, in case of sale of goods, is revenue to be recognized on receipt of the customer order, on completion of production, on the date of shipment, or on delivery of goods to the customer ? The decision as to when and how revenue should be recognized has a significant impact on the determination of “net income” for the year (i.e., the “bottom line”), and thus it is a very critical element in the entire process of the preparation of the financial statements.

Revenue from the sale of goods should be recognized when all of the following criteria are satisfied :

(a) the significant risks and rewards of ownership of the goods have been transferred to the buyer

(b) the seller retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold

(c) the amount of the revenue can be reliably measured

(d) it is probable that economic benefits associated with the transaction will flow to the seller

(e) the costs incurred or to be incurred in respect of the transaction can be measured reliably.

The transfer of “significant” risks and rewards is essential. For example, if goods are sold but the receivable will be collected only if the buyer is able to sell, then “significant” risks of ownership are retained by the original seller and no sale is recognized.

The point of time at which significant risks and rewards of ownership transfer to the buyer requires careful consideration involving examining the circumstances surrounding the transaction. Generally, the transfer of significant risks and rewards of ownership takes place when title passes to the buyer or the buyer received possession of the goods. However, in some circumstances, the transfer of risks and rewards of ownership does not coincide with transfer of legal title or the passing of possession, as when a building that is still under construction is sold.

Revenue from the rendering of services can be recognized by reference to stage of completion if the final outcome can be reliably estimated. This would be the case if :

(a) the amount of revenue can be measured reliably

(b) it is probable that economic benefits associated with the transaction will flow to the seller

(c) the stage of completion can be measured reliably

(d) the cost incurred and the cost to complete can be measured reliably.

Revenue arising from the use by others of an entity’s asset that yield interest, dividends, or royalties are recognized in this way :

(a) Interest is recognized using the “effective interest method”

(b) Royalties are recognized on an accrual basis in accordance with the royalty agreement

(c) Dividends are recognized when the shareholder has a right to receive payment.

Source of this article : IFRS Practical Implementation Guide and Workbook (Second Edition) - Abbas Ali Mirza, Magnus Orrell and Graham J. Holt

For further reference, read also a related article from regarding on Revenue Recognition in here >>

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