The concept of revenue recognition states that the revenue should be recorded in the books of accounts of business when the revenue is earned/realized no matter the actual cash is received or not against such revenue or in other words the revenue is considered to be earned at the point of time when the goods and services are sold and the associated risk & rewards are transferred to the buyer.
Explanation with Example:
Revenue refers to the inflow of cash by sale of goods or rendering of services etc. these revenues are recognized at the point of time when there is actual sale of goods and services not at the time when money is received against such sale. In other words, revenue is recognized when the business is entitled to receive payment and not when the payment is received. For example, Mr. A sold goods on 3 month credit to Mr. B on March 29th, 2018. Mr. B can now pay the amount within 3 months but in the books of Mr. A the sales will be recorded on March 29th not at the time when actual cash is paid by Mr. B.
Other ways of earning revenues apart from sale of goods and services are earning interest income, dividend income, rental income, royalties etc. and they are recorded when they become due to be received. For example interest on fixed deposits are accumulated and are received at the time of maturity but interest pertaining to each financial year is recognized as revenue in the income statement of each financial year till the time Fixed deposit is matured. Let’s take the example of XYZ incorporation that has made a fixed deposit (FD) of $20,000 at a compound interest of 10%p.a. compounded annually with the bank on 1st April, 2019 for a period of 5 years. The total interest plus the amount FD is receivable at the end of 5 years i.e. on 31st March 2024. The Accounting period of XYZ incorporation is April to March. Now at the end of financial year on March, 2020, the interest income will be recognized as $2,000 ($20,000*10%). Similarly at the end of each accounting period till March, 2024 interest income will be recognized and interest is calculated on compounded amount.
The advantages of revenue recognition concept are:
- The revenue recognition concept reflects a clearer picture of revenue earned in an accounting year and therefore it is important to book correct profit in each accounting year.
- Revenue recognition reduces the chance of inflating profits & revenues of the business thereby maintaining the credibility of finances.
- The standard guideline for revenue recognition helps in the comparison, both inter and intra enterprises.
The disadvantages of revenue recognition concept are:
- When the completion of any product takes longer duration then in such a case applying revenue recognition principle is difficult.
- As the revenue is reported when the cash is entitled to be received, taxes are paid even if the cash is not received against the revenue.