What is Revenue Recognition?
Revenue recognition is the process in which you should calculate your revenue for the current period. This includes figuring out what income tax rate to use, recognizing revenues that have been deferred, marking them off the balance sheet only when they are legally received, and compounding interest for any delays in receiving cash. It is the process of recognizing (or recording) revenue. The concept of “when” to recognize revenue is important, because if different accounting methods are used, the bottom-line net income will be affected. The rules for determining when to recognize revenue are fairly straightforward; however, there are some complexities that can arise. The complexity arises primarily from transactions that specifically do not qualify as revenues or that may defer recognition of revenue until later in time periods.
Recognition is something which must be done by all businesses so they may show their financial information fairly on balance sheets and income statements. The objective of this process is to correctly and fairly record the amount of money received and the cost associated with providing goods and services. Revenue recognition is a significant component of financial accounting. The issues relating to revenue recognition can be very complex. For example, one question that arises frequently relates to how much effort should be expended in order to obtain payment from credit customers. Existing business may be extended additional credit based on the quality of their historical operations, but new customers usually receive less favorable terms until they establish themselves as reliable payers. Many companies choose to write off accounts receivable when it is obvious that they will not be able to collect the money owed. This issue often arises when the debt is uncollectible and the cost of collection exceeds the amount that can be realized in a liquidation or sale of assets. It is important to note that revenue recognition requirements differ depending on how long it has been since the transaction occurred and whether or not credit customers are involved. The following sections discuss these distinctions and address various other issues related to revenue recognition.
When revenue is recognized depends on the type of goods or services that were sold. The two major factors that affect how long it can take for revenue recognition are
(1) whether the contract provides for performance over time, and
(2) whether the company is using an accrual basis of accounting.
Revenue recognition for companies with contracts providing for performance over time is discussed in Reference 1. Companies using an accrual basis of accounting generally recognize revenue when all four important criteria are met. There are several issues involving revenue recognition which are not specifically tied to when the revenue is recognized. These issues are related to the accounting for
(1) leases,
(2) delivery orders,
(3) prepaid expenses and
(4) deferred costs.
A company can recognize revenue in advance of when the product is sold. This is true in the case of sales to customers who do not make frequent purchases or in long-term contracts. If this occurs, the cost of the item must be included in inventory at that time. This allows for revenue recognition when the item is sold by reducing the amount on hand inventory. An important aspect of determining when revenue should have been recognized relates to how it affects current income. If revenue is recognized too soon or too late, it can have a significant effect on net income. The following examples illustrate the importance of revenue recognition. When you are running your own small business, accounting for business expenses can be difficult enough without adding additional complications. Revenue recognition is a process with four primary steps:
Step 1: Determining the Revenues in a Quarterly or Annual Period
Revenue in a calendar year that you need to track. These revenues are totaled in your income statement in your quarterly tax filing, and then in your annual return on taxes. Because you will be recording these costs in books that are going to be used for accounting purposes for quite some time, it is important to make sure that the accounts treated as revenue have been properly accrued or charged off when they should have been. You can use the chart below to help determine if any of the amounts have been accrued or charged off.
Step 2: Identifying the Revenues that have been Deferred
Revenues may have been deferred for a number of reasons, but most commonly they were either incurred during one accounting period but received in another, or due to circumstances involving the timing of cash receipts and cash payments. It is important to account for these revenues in your financial statements so they do not have to be expensed multiple times. For example, if sales are made on credit to your customers over the course of several months, each sale will generally be recorded at that time. However, you will eventually receive all or some of those sales back as cash payments with interest earned on the amount owed by your customers.
Step 3: Marking the Deferred Revenue to the Income Statement When it is Not Being Used
You need to determine whether or not you can defer revenue for these amounts, and if so, record them as deferred revenue on your income statement. This will be true for any revenues you can defer because if certain costs (such as interest costs) are also deferred then they will also be later expensed. Some examples of deferred revenue are resales of your inventory sold to customers that will be returned at their end of the year, prepaid expenses like invoices that vendors will provide before you receive them (prepaid expense), and prepaid legal services by an attorney that you will use later.
Step 4: Compute Impairment of Deferred Revenue
There may be times when you need to take impairment of deferred revenue. This could be for reasons such as if sales are lower than anticipated, the customers to whom the sales were made go bankrupt before you received payment, or another reason to make it impossible for you to recover this money. Some examples include significant changes to your revenue estimations through the course of the next reporting period, or if it is clear that these revenues will not come in at all. It does not matter how accurately you forecasted your revenues because even the best forecasting period can be significantly different than what actually happens within that time period.
Business managers should have a strong understanding of their business processes before attempting to calculate revenue recognition. If additional information is required or business managers are unable to handle this important task on their own, they can always reach out Fintalent, the collaborative platform for tier-1 Strategy and M&A Professionals for additional guidance and appropriate tax preparation.
