A company’s financial records should reflect revenue from the sale when the [...] and [...] of ownership is transferred.
Answer
risk and reward
This is often when the company delivers the goods or services.
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Open it A fundamental principle of accrual accounting is that revenue is recognized when it is earned, so the company’s financial records reflect revenue from the sale when the risk and reward of ownership is transferred; this is often when the company delivers the goods or services.
Original toplevel document
3. REVENUE RECOGNITION lace and measures revenue at the amount of cash received. In practice, however, determining when revenue should be recognized and at what amount is considerably more complex for reasons discussed in the following sections.
<span>3.1. General Principles
An important aspect concerning revenue recognition is that it can occur independently of cash movements. For example, assume a company sells goods to a buyer on credit, so does not actually receive cash until some later time. A fundamental principle of accrual accounting is that revenue is recognized (reported on the income statement) when it is earned, so the company’s financial records reflect revenue from the sale when the risk and reward of ownership is transferred; this is often when the company delivers the goods or services. If the delivery was on credit, a related asset, such as trade or accounts receivable, is created. Later, when cash changes hands, the company’s financial records simply reflect that cash has been received to settle an account receivable. Similarly, there are situations when a company receives cash in advance and actually delivers the product or service later, perhaps over a period of time. In this case, the company would record a liability for unearned revenue when the cash is initially received, and revenue would be recognized as being earned over time as products and services are delivered. An example would be a subscription payment received for a publication that is to be delivered periodically over time.
When to recognize revenue (when to report revenue on the income statement) is a critical issue in accounting. IFRS specify that revenue from the sale of goods is to be recognized (reported on the income statement) when the following conditions are satisfied:11
the entity has transferred to the buyer the significant risks and rewards of ownership of the goods;
the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;
the amount of revenue can be measured reliably;
it is probable that the economic benefits associated with the transaction will flow to the entity; and
the costs incurred or to be incurred in respect of the transaction can be measured reliably.
In simple words, this basically says revenue is recognized when the seller no longer bears risks with respect to the goods (for example, if the goods were destroyed by fire, it would be a loss to the purchaser), the seller cannot tell the purchaser what to do with the goods, the seller knows what it expects to collect and is reasonably certain of collection, and the seller knows how much the goods cost.
IFRS note that the transfer of the risks and rewards of ownership normally occurs when goods are delivered to the buyer or when legal title to goods transfers. However, as noted by the above remaining conditions, physical transfer of goods will not always result in the recognition of revenue. For example, if goods are delivered to a retail store to be sold on consignment and title is not transferred, the revenue would not yet be recognized.12
IFRS specify similar criteria for recognizing revenue for the rendering of services.13 When the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction shall be recognized by reference to the stage of completion of the transaction at the balance sheet date. The outcome of a transaction can be estimated reliably when all the following conditions are satisfied:
the amount of revenue can be measured reliably;
it is probable that the economic benefits associated with the transaction will flow to the entity;
the stage of completion of the transaction at the balance sheet date can be measured reliably; and
the costs incurred for the transaction and the costs to complete the transaction can be measured reliably.
IFRS criteria for recognizing interest, royalties, and dividends are that it is probable that the economic benefits associated with the transaction will flow to the entity and the amount of the revenue can be reliably measured.
US GAAP14 specify that revenue should be recognized when it is “realized or realizable and earned.” The US Securities and Exchange Commission (SEC),15 motivated in part because of the frequency with which overstating revenue occurs in connection with fraud and/or misstatements, provides guidance on how to apply the accounting principles. This guidance lists four criteria to determine when revenue is realized or realizable and earned:
There is evidence of an arrangement between buyer and seller. For instance, this would disallow the practice of recognizing revenue in a period by delivering the product just before the end of an accounting period and then completing a sales contract after the period end.
The product has been delivered, or the service has been rendered. For instance, this would preclude revenue recognition when the product has been shipped but the risks and rewards of ownership have not actually passed to the buyer.
The price is determined, or determinable. For instance, this would preclude a company from recognizing revenue that is based on some contingency.
The seller is reasonably sure of collecting money. For instance, this would preclude a company from recognizing revenue when the customer is unlikely to pay.
Companies must disclose their revenue recognition policies in the notes to their financial statements (sometimes referred to as footnotes). Analysts should review these policies carefully to understand how and when a company recognizes revenue, which may differ depending on the types of product sold and services rendered. Exhibit 4 presents a portion of the summary of significant accounting policies note that discusses revenue recognition for DaimlerChrysler (DB-F: DAI) from its 2009 annual report, prepared under IFRS.
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