Question

What are the revenue recognition criteria that must be satisfied before a company can recognize revenue?

Answer 1

Answer:

Revenue recognition is a generally accepted accounting principle (GAAP) that determines the specific conditions in which revenue is recognized or accounted for. Generally, revenue is recognized only when a critical event has occurred, and the amount of revenue is measurable.

In order for revenue recognition to be achieved, it must meet two key conditions:

Persuasive evidence of an arrangement exists;

Delivery has occurred or services have been rendered;

The seller's price to the buyer is fixed or determinable; and.

Collectibility is reasonably assured”.

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.

The five key steps a company follows to apply the core revenue recognition principle:

The Five-Step Method

Step 1: Identify the contract with a customer.

Step 2: Identify the performance obligations in the contract.

Step 3: Determine the transaction price.

Step 4: Allocate the transaction price to the performance obligations in the contract.

Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.

Example for revenue recognition:

Bob builds fences. On the last day of June, he has almost finished constructing a nice privacy fence for Joe. The only thing that he has left to do is to install a gate. The gate is scheduled to arrive from the supplier the next day. Bob gives Joe the invoice for the cost of constructing the fence and promises to install the gate as soon as it comes in. Joe won't be paying Bob until the next day, when the job is 100% complete. Since it's the end of the accounting period and payment will not be received until the first day of the new accounting period, does Bob claim the revenue in this period or in the next?

Bob counts the revenue in the current accounting period, even though the payment has not been received yet. Why? Because the situation meets all criteria needed for revenue to be recognized and recorded. He has almost 100% completed the job, he's confident that payment will be received, the revenue is earned and realizable. It also meets the standard set by the matching principle, since the expenses that Bob incurred to erect the fence occurred in this accounting period, even though pay won't be received until the next period.