Recognition is the process of formally recording and reporting an item in the financial statements. Realization is the process of converting noncash resources into cash or rights to cash. A company usually recognizes revenue in the period of sale, when (a) realization
has taken place, and (b) the revenues have been earned. There are, however, three revenue recognition alternatives: (a) advanced recognition (e.g., during the period of production), (b) recognition at the time of sale, and (c) deferred recognition (e.g., upon receipt of cash). Advanced or deferred recognition is used to increase the usefulness of the financial statements.
The revenue recognition alternative used affects not only a company’s income recognition on its income statement but its measurement of net assets (assets minus liabilities) on its balance sheet. Under all three revenue recognition alternatives, a company increases related assets
from cost to selling price at the point at which it recognizes revenue and expenses. For example, in a manufacturing operation, when revenue recognition is at the time of sale, accounts receivable is increased by the selling price and inventory is reduced by the cost. When recognition is advanced, revenue and expense are recognized during production, and the inventory is increased from cost to selling price. When
recognition is delayed, the sale is recorded in the accounts receivable at the selling price, but accounts receivable is reduced to cost by recording the expected gross profit in a Deferred Gross Profit account (a contraaaccount to accounts receivable). As payment is receive.:!, Deferred Gross Profit is debited and Gross Profit is credited, thus recognizing revenue, and increasing net assets by the selling price.
The recognition of expenses is matched against revenues and coincides with the revenue recognition alternative selected when there is a direct “association of cause and effect.” For example, depreciation expense on machinery to produce a product is included in the cost of inventory and its recognition is consistent with the recognition of revenue. However, when expenses are recognized on the basis of .systematic and rational allocation (depreciation on an office building for administrative purposes) or immediately (administrative salaries), the recognition of expenses is independent of the revenue recognition alternative used.
The following three factors are useful in evaluating revenue recognition issues in specific business situations. The factors may help in determining whether revenue should be recognized at the time of sale, or whether recognition should be advanced or deferred.
- The economic substance of the event takes precedence Over the legal form of the transaction.
- Usually a company recognizes revenue at the time of the legal transaction. However, revenue recognition may, be advanced or delayed if economic “reality” would otherwise be substantially distorted. An example is the recognition of gross profit on a sales type lease by the lessor before legal title is passed.
- The risks and benefits of ownership been transferred to the buyer.
- If the risks and benefits have been substantially transferred, the buyer must recognize revenue. Under a sales-type lease, the lessor must recognize revenue even though no legal sale has occurred because the risks and benefits of ownership have been transferred.
- The collectability of the receivable from the sale is reasonably assured.
- If collectability is not reasonably assured, revenue has not been realized and the earning process is not complete so recognition is deferred.