Monday, March 1, 2010

Revenue Recognition

Holi Greetings to everyone!!

On this Festival of Colors "Holi" 

May God gift you all the colors of life,
colors of joy, colors of happiness,
colors of friendship,
colors of love and all other colors you want to paint in your life.

Happy Holi!!

It is a spring festival, celebrated at the end of the winter season on the last full moon day of the lunar month Phalguna (February/March), signifying dawn, light, life and a surge of energy. It begins at night by litting the bonfires a day before, suggesting destruction of evil and a hope for good.
I acquiesce with another delay on my part and admit my dereliction of duty and commitment. However, as Aprajita (undefeatedly) I will continue with my effort.

In this posting, I am going to talk about Revenue Recognition. Revenue is one of the most important indicators of a successful business. Since revenue reporting directly impacts an entity's results of operations and financial position, it is essential to have a thorough knowledge of the underlying concepts and practices.  However, revenue accounting literature has emanated in various diverse pronouncements that at times it is often challenging to relate and identify the appropriate pronouncement. I get down to it by discussing the following two important Statements of Financial Accounting Concepts(SFAC):
  • SFAC 5, Recognition and Measurement in Financial Statements of Business Enterprises giving recognition guidance and
  • SFAC 6, Elements of Financial Statements giving presentation guidance.
The terms REALIZED and REALIZABLE focuses on conversion or convertibility of noncash assets into cash or claims to cash (SFAC 6). They identify revenues or gains or losses on assets sold and unsold, respectively. RECOGNITION is the process of formally recording an item in the financial statements of an entity.

Per SFAC 5, revenues and gains are recognized when they are both realized/realizable and earned. Revenues are considered to have been EARNED when the entity has significantly completed its key activities (purchasing, manufacturing, selling, rendering service, delivering goods, allowing other entities to use enterprise assets etc.) thereby, entitling it to the benefits represented by the revenues.
Since gains generally involve no EARNING process, it is more significant for them being realized or realizable.

It is important to understand the timing of revenue recognition as it can have a significant impact on an entity's results of operations. Consider the following situations where (i) revenue is realized and earned at the same time (ii) revenue is realized before it is earned  and (iii) revenue is earned before it becomes unrealizable:
  • The customer pays for the merchandise at the cash register to retail store owner or when a manufacturer processes COD orders.
  • Payment for magazine subscription or rent in advance.
  • Manufacturer delivers and sells the products on credit.
Several transactions have been guided by other pronouncements on revenue recognition and are considered exception to SFAC 5. To mention a few:
  1. ASC 605-10-25-3, Installment and Cost Recovery Methods of Revenue Recognition (APB 10)
  2. ASC 605-15-25, Revenue Recognition When Right of Return Exists (FAS 48)
  3. ASC 605-35, Long-Term Construction-Type Contracts (ARB 45) 
  4. ASC 605-35, Accounting for Certain Production-Type Contracts (SOP 81-1)
  5. ASC 985-605, Software Revenue Recognition (SOP 97-2)
  6. ASC 952-605, Franchise Fee Income, Royalty (FAS 45)
Keeping in mind the various pronouncements on revenue recognition, generally speaking, following four conditions must be met in order for revenue to be both earned and realizable:

1. Persuasive evidence of an arrangement exists.
2. The arrangement fee is fixed or determinable.
3. Delivery or performance has occurred.
4. Collectibility is reasonably assured.

If any of the afore-said conditions is not satisfied in an accounting period, revenue recognition must be deferred until the period in which the final condition is met.

This was a brief introduction to the conceptual framework on revenue recognition. I will dig deeper into this topic in my next post.

Until then......Goodbye, Au revoir and Sayonara.




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