Publicly traded companies must comply with revenue recognition rules before they can accrue revenue, i.e., declare it as income in their public reporting. Revenue recognition rules are very important drivers in sales transactions and purchasers who are aware of the rules can often use them to their advantage in bargaining. Under U.S. (FASB) rules there are two tests that revenue must fulfill before it can be declared
(1) Completion of the earnings process, i.e., the vendor must have no significant remaining obligations to the customer, so if under the sales contract some major element remains to be delivered, the revenue cannot be recognized—in addition if there is a return period, i.e., the customer can return the goods for refund for a certain period of time, the revenue cannot be recognized until that time has elapsed;
(2) Assurance of payment, i.e., the vendor must be reasonably that it will be paid.
Under International Accounting Standards the rules are expressed somewhat differently. IAS 18 makes provision for goods and services. With respect to goods, revenue can be recognized once;
- the vendor has transferred to the buyer the significant risks and rewards of ownership, which also requires that,
– the vendor retains neither continuing managerial involvement to the degree usually associated with ownership, nor effective control over the goods sold;
– the amount of revenue the vendor will derive from the transaction can be measured reliably, i.e., reasonably accurately;
– it is probable that the economic benefits associated with the transaction will flow to the vendor, i.e., that it is the vendor who will receive payment; and
– the costs incurred or to be incurred, by the vendor, in respect of the transaction can be reliably measured.
With respect to services, IAS 18 provides that revenue can be recognized once;
- the amount of revenue the vendor will derive from the transaction can be measured reliably, i.e., reasonably accurately;
- it is probable that the economic benefits associated with the transaction will flow to the vendor, i.e., that it is the vendor who will receive payment;
- the stage of completion of the delivery of services at the balance sheet date, for which revenue is being recognized, can be measured reliably; and
- the costs incurred, or to be incurred, by the vendor, in respect of the transaction can be measured reliably.