When is the appropriate time to recognize revenue?

In the ever changing business environment, companies are developing new ways to attract and maintain customers. As a result, these new methods of selling products generate questions regarding recognition of revenue in financial statements.

Ordinarily, profit is recognized at the time of sale. Accordingly, revenue should be recognized when a transaction is completed. Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, states that revenue is recorded in the financial statements when the following conditions are met:

1. The revenue is realized or realizable (converted or convertible to cash or claim to cash).
2. The revenue has been earned (activities prerequisite to obtaining benefits have been completed).

Therefore, revenue from selling products should be recognized at the date of sale and revenue from rendering services should be recognized when the services have been performed and are billable.

Generally, recognizing revenue before and after delivery of products or services is not acceptable under generally accepted accounting principles. However, there are some transactions in which receivables are collected over an extended period of time and their collectibility cannot be reasonably estimated. In these circumstances, revenue is recognized under the installment method or the cost-recovery method. Under the installment method, profit is recognized as proceeds are received. Under the cost-recovery method, no profit is recognized until all costs are recovered.

In certain circumstances, a customer may be allowed to return merchandise for refund, credit or exchange during a specified period following the sale. In such cases, ownership has not been transferred from the seller to the buyer. Consequently, the sale has not been completed and revenue should not be recognized. If an enterprise sells its product but gives the buyer the right to return the product, revenue from the transaction is recognized at time of sale only if all of the following conditions are met:

1. The seller’s price to the buyer is substantially fixed or determinable at the date of sale.
2. The buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on reselling the merchandise.
3. The buyer’s obligation to the seller would not change if the merchandise were stolen, damaged or destroyed.
4. The buyer has economic substance.
5. The seller has no significant obligation to help the buyer resell the merchandise.
6. The amount of returns can be reasonably estimated.

Many companies may also offer separately priced service or extended warranty contracts when merchandise is sold. These type of contracts often cover a stated period and provides the customer warranty protection, routine periodic maintenance or both. Revenue from these types of contracts should be deferred at the time of sale and recognized over the life of the contract.

As there may be accounting guidance specific to the industry or individual transactions, the appropriate method for recognizing revenue should be made after consideration of all facts and circumstances. We can help you determine the appropriate method for recognizing revenue in your financial statements under generally accepted accounting principles.

- Hue Tran
Assurance Services Dept.