Business Requirement: Accrual Accounting Matching Principle Accounting Period Revenues Expenses

Business requirement
The revenue recognition principle is a

cornerstone of accrual accounting together
with the matching principle. They both
determine the accounting period, in
which revenues and expenses are
recognized. According to the principle,
revenues are recognized when they
are realized or realizable, and are earned
(usually when goods are transferred or
services rendered), no matter when cash
is received. In cash accounting – in
contrast – revenues are recognized when
cash is received no matter when goods or
services are sold.
Cash can be received in an earlier or later
period than obligations are met (when
goods or services are delivered) and
related revenues are recognized that
results in the following two types of
accounts:
 Accrued revenue: Revenue is

recognized before cash is received.
 Deferred revenue: Revenue is
recognized after cash is received.
Revenue realized during an accounting
period is included in the income.
Contents
 1International Financial Reporting Standards

criteria
 2General rule
o 2.1Revenue versus cash timing
o 2.2Advances
 3Exceptions
o 3.1Revenues not recognized at sale
o 3.2Revenues recognized before sale
 3.2.1Long-term contracts
 3.2.2Completion of production
basis
o 3.3Revenues recognized after Sale
 4New Revenue Recognition Standard
 5References
 6Sources
International Financial
Reporting Standards
criteria[edit]
The Critical-Event
Approach: IFRS provides five criteria for
identifying the critical event for recognizing
revenue on the sale of goods:[1]
1. Risks and rewards have been

transferred from the seller to the
buyer
2. The seller has no control over the
goods sold
3. Collection of payment is
reasonably assured
4. The amount of revenue can be
reasonably measured
5. Costs of earning the revenue can
be reasonably measured
The first two criteria mentioned above are
referred to as Performance. Performance
occurs when the seller has done most or
all of what it is supposed to do to be
entitled for the payment. E.g.: A company
has sold the good and the customer walks
out of the store with no warranty on the
product. The seller has completed its
performance since the buyer now owns
good and also all the risks and rewards
associated with it. The third criterion is
referred to as Collectability. The seller
must have a reasonable expectation of
being paid. An allowance account must be
created if the seller is not fully assured to
receive the payment. The fourth and fifth
criteria are referred to as Measurability.
Due to Matching Principle, the seller must
be able to match expenses to the
revenues they helped in earning.
Therefore, the amount of Revenues and
Expenses should both be reasonably
measurable
General rule[edit]
Received advances are not recognized as
revenues, but as liabilities (deferred
income), until the conditions (1.) and (2.)
are met.
1. Revenues are realized when cash

or claims to cash (receivable) are
received in exchange for goods or
services. Revenues are realizable
when assets received in such
exchange are readily convertible
to cash or claim to cash.
2. Revenues are earned when such
goods/services are
transferred/rendered. Both such
payment assurance and final
delivery completion (with a
provision for returns, warranty
claims, etc.), are required for
revenue recognition.
Recognition of revenue from four types of
transactions:
1. Revenues from
selling inventory are recognized at
the date of sale often interpreted
as the date of delivery.
2. Revenues from rendering services
are recognized when services are
completed and billed.
3. Revenue from permission to use
company's assets (e.g. interests
for using money, rent for
using fixed assets, and royalties
for using intangible assets) is
recognized as time passes or as
assets are used.
4. Revenue from selling an asset
other than inventory is recognized
at the point of sale, when it takes
place.
Revenue versus cash
timing[edit]
Accrued revenue (or accrued assets) is an
asset such as proceeds from a delivery of
goods or services, at which such income
item is earned and the
related revenue item is recognized, while
cash for them is to be received in a
later accounting period, when its amount is
deducted from accrued revenues. It shares
characteristics with deferred
expense (or prepaid expense,
or prepayment) with the difference that an
asset to be covered later is cash paid out
to a counterpart for goods or services to be
received in a later period when the
obligation to pay is actually incurred, the
related expense item is recognized, and
the same amount is deducted
from prepayments
Deferred revenue (or deferred income) is
a liability, such as cash received from a
counterpart for goods or services which
are to be delivered in a later accounting
period, when such income item is earned,
the related revenue item is recognized,
and the deferred revenue is reduced. It
shares characteristics with accrued
expense with the difference that a liability
to be covered later is an obligation to pay
for goods or services received solo from a
counterpart, while cash for them is to be
paid out in a later period when its amount
is deducted from accrued expenses.
For example, a company receives an
annual software license fee paid out by a
customer upfront on the January 1.
However the company's fiscal year ends
on May 31. So, the company using accrual
accounting adds only five months worth
(5/12) of the fee to its revenues in profit
and loss for the fiscal year the fee was
received. The rest is added to deferred
income (liability) on the balance sheet for
that year.
Advances[edit]
Advances are not considered to be a
sufficient evidence of sale, thus no
revenue is recorded until the sale is
completed. Advances are considered
a deferred income and are recorded
as liabilities until the whole price is paid
and the delivery made
(i.e. matching obligations are incurred).
Exceptions[edit]
Revenues not recognized at
sale[edit]
The rule says that revenue from
selling inventory is recognized at the point
of sale, but there are several exceptions.
 Buyback agreements: buyback

agreement means that a company
sells a product and agrees to buy it
back after some time. If buyback price
covers all costs of the inventory plus
related holding costs, the inventory
remains on the seller's books. In plain:
there was no sale.
 Returns: companies which cannot
reasonably estimate the amount of
future returns and/or have extremely
high rates of returns should recognize
revenues only when the right to return
expires. Those companies that can
estimate the number of future returns
and have a relatively small return rate
can recognize revenues at the point of
sale, but must deduct estimated future
returns.
Revenues recognized before
sale[edit]
Long-term contracts[edit]
This exception primarily deals with long-
term contracts such as constructions
(buildings, stadiums, bridges, highways,
etc.), development of aircraft, weapons,
and space exploration hardware. Such
contracts must allow the builder (seller) to
bill the purchaser at various parts of the
project (e.g. every 10 miles of road built).
 The percentage-of-completion
method says that if the contract
clearly specifies the price and payment
options with transfer of ownership, the
buyer is expected to pay the whole
amount and the seller is expected to
complete the project, then revenues,
costs, and gross profit can be
recognized each period based upon
the progress of construction (that is,
percentage of completion). For
example, if during the year, 25% of the
building was completed, the builder
can recognize 25% of the expected
total profit on the contract. This
method is preferred. However,
expected loss should be recognized
fully and immediately due to
conservatism constraint. Apart from
accounting requirement, there is a
need for calculating the percentage of
completion for comparing budgets and
actuals to control the cost of long-term
projects and optimize Material, Man,
Machine, Money and time (OPTM4)
.The method used for determining
revenue of a long-term contract can be
complex. Usually two methods are
employed to calculate the percentage
of completion: (i) by calculating the
percentage of accumulated cost
incurred to the total budgeted cost. (ii)
by determining the percentage of
deliverable completed as a percentage
of total deliverable. The second
method is accurate but cumbersome.
To achieve this, one needs the help of
a software ERP package which
integrates Financial, inventory, Human
resources and WBS (Work breakdown
structure) based planning and
scheduling while booking of all cost
components should be done with
reference to one of the WBS elements.
There are very few contracting ERP
software packages which have the
complete integrated module to do this.
 The completed-contract
method should be used only if
percentage-of-completion is not
applicable or the contract involves
extremely high risks. Under this
method, revenues, costs, and gross
profit are recognized only after the
project is fully completed. Thus, if a
company is working only on one
project, its income statement will show
$0 revenues and $0 construction-
related costs until the final year.
However, expected loss should be
recognized fully and immediately due
to conservatism constraint.
Completion of production basis[edit]
This method allows recognizing revenues
even if no sale was made. This applies to
agricultural products and minerals.There is
a ready market for these products with
reasonably assured prices, the units are
interchangeable, and selling and
distributing does not involve significant
costs.
Revenues recognized after

Sale[edit]
Sometimes, the collection of receivables
involves a high level of risk. If there is a
high degree of uncertainty regarding
collectibility then a company must defer
the recognition of revenue. There are three
methods which deal with this situation:
 Installment sales method allows

recognizing income after the sale is
made, and proportionately to the
product of gross profit percentage and
cash collected calculated. The
unearned income is deferred and then
recognized to income when cash is
collected.[2] For example, if a company
collected 45% of total product price, it
can recognize 45% of total profit on
that product.
 Cost recovery method is used when
there is an extremely high probability
of uncollectable payments. Under this
method no profit is recognized until
cash collections exceed the seller's
cost of the merchandise sold. For
example, if a company sold a machine
worth $10,000 for $15,000, it can start
recording profit only when the buyer
pays more than $10,000. In other
words, for each dollar collected greater
than $10,000 goes towards your
anticipated gross profit of $5,000.
 Deposit method is used when the
company receives cash before
sufficient transfer of ownership occurs.
Revenue is not recognized because
the risks and rewards of ownership
have not transferred to the buyer.[3]
 Generally accepted accounting
principles
 Comparison of cash and accrual
methods of accounting
 Vendor-specific objective evidence
New Revenue
Recognition Standard[edit]
On May 28, 2014, the FASB and IASB
issued converged guidance on recognizing
revenue in contracts with customers. The
new guidance is heralded by the Boards
as a major achievement in efforts to
improve financial reporting.[4] The update
was issued as Accounting Standards
Update (ASU) 2014-09. It will be part of
the Accounting Standards Codification
(ASC) as Topic 606: Revenue from
Contracts with Customers (ASC 606), and
supersedes the existing revenue
recognition literature in Topic 605 issued
by FASB.[5] ASC 606 is effective for public
entities for the first interim period within
annual reporting periods beginning after
December 15, 2017 (nonpublic companies
have an additional year).[6]
The new standard aims to:
 Remove inconsistencies and

weaknesses in revenue requirements
 Provide a more robust framework for
addressing revenue issues
 Improve comparability of revenue
recognition practices across entities,
industries, jurisdictions, and capital
markets
 Provide more useful information to
users of financial statements through
improved disclosure requirements
 Simplify the preparation of financial
statements by reducing the number of
requirements to which an entity must
refer[5]
The new revenue guidance was issued by
the IASB as IFRS 15. The IASB’s
standard, as amended, is effective for the
first interim period within annual reporting
periods beginning on or after January 1,
2018, with early adoption permitted.[7]

Business Requirement: Accrual Accounting Matching Principle Accounting Period Revenues Expenses

Uploaded by

Copyright:

Available Formats

Business Requirement: Accrual Accounting Matching Principle Accounting Period Revenues Expenses

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Business Requirement: Accrual Accounting Matching Principle Accounting Period Revenues Expenses

Uploaded by

Copyright:

Available Formats

Business requirement

The revenue recognition principle is a

 Accrued revenue: Revenue is

 1International Financial Reporting Standards

1. Risks and rewards have been

1. Revenues are realized when cash

 Buyback agreements: buyback

Revenues recognized after

 Installment sales method allows

 Remove inconsistencies and

You might also like