Understanding the point at which sales can actually be recognised within your business’ financial statements is a crucial step in preparing a set of accounts. In this post we look at the revenue recognition policies set out under FRS 102.
Revenue is shown on the income statement as it relates to a business’ profit and loss. It is recognised under the accruals basis, which means it must be recorded when it is earned, not when the cash is actually received. To begin with we will understand what revenue actually means.
What is Revenue?
Revenue is another word for the sales that a business makes. Revenue can take many forms but most of these can be narrowed down into the following 2 categories:
- Sale of Goods
- Rendering of a Service
If a business makes or buys a certain product to re-sell then this its revenue would be classed as “sale of goods”. A few examples of this type of business are supermarkets, car dealerships and restaurants.
If a business does not sell a physical product but instead provides a service to its customers, its revenue would be classed as the “rendering of a service”. Some examples of this include window cleaners, barbers and consulting firms.
Any time a business provides a product or service to a customer this is classed as a sale and must be recorded as revenue within its financial statements.
What Does Revenue Recognition Mean?
Just because a sale has been made in the eyes of a business, this doesn’t mean that it is right to record it in the accounts.
Let’s say a customer walks into a car dealership and finds a car they want to buy. Imagine a shop that makes bespoke suits. A customer comes in Monday and gets measured up for a suit, he pays on the day and agrees to come back on Friday to collect his suit.
In this situation the shop would probably say they have made a sale; the customer has paid in full so in their opinion the sale is a done deal. The customer however may have a different view; yes they have paid for the suit but until they come back and collect it, the sale is not complete.
This is where revenue recognition comes into play.
The revenue recognition guidance under FRS 102 allows accountants to determine at which point a sale can be recorded in a company’s accounts as revenue.
At Which Point can Revenue be Recognised for the Sale of Goods Under FRS 102
The main condition for recognising revenue is that:
The significant risk and rewards of ownership have been transferred to the buyer.
This condition carries with it an element of subjectivity, but after a bit of thought about the items being sold, it is usually quite easy to see when this condition has been met.
If we take the example of the suit again. The reward of owning a suit is that you get to wear it and look good. If the customer has not yet picked up their suit then this is not possible and therefore, the rewards have not yet been transferred to the buyer.
The risk side can be more confusing to work out. What are the risks of owning a suit? Realistically there are 2 risks of owning a suit:
- Somebody may steal the suit
- The suit may get damaged.
In either case, it is pretty clear to see that if the suit was stolen from the store or had a big coffee stain on it when the customer came to pick it up – the customer would probably be entitled to get their money back (or have another suit made).
Therefore, it can be determined that until the customer has actually collected their suit, revenue should not be recognised.
Another condition that must be met to recognise revenue is:
It is probable that the economic benefits will flow to the entity.
In essence, this point means that the customer is going to pay. If a company sells an item to a company that has recently gone insolvent, it is unrealistic to expect the company to pay and therefore it is NOT probable that the economic benefits will flow to the entity.
In our example, the customer has already paid for the goods so it would be fairly to assume this condition has been met (the economic benefits have already flowed to the entity). However, there must be some consideration given to the likelihood of a refund being made.
Imagine the customer had asked for the suit to be made in a super-rare material. We agree to make the sale but after the customer leaves we find out that it it practically impossible to obtain that material. It is now fair to assume that we probably aren’t going to be able to fulfill the customers order and there is a high chance that the “economic benefits” will have to flow back to the buyer.
The other main condition which must be met is:
The amount of revenue can be measured reliably
This condition of revenue recognition is usually the most simple one to understand. It simply means that we must understand the price the customer is going to pay before we can recognise revenue.
For most sales, we would expect an invoice to have been raised to the customer stating the amount due. This is a clear indicator that the revenue from the sale can be reliably measured.
In our case, the customer has already paid up-front, so we know exactly how much revenue has been generated from the sale, before the other revenue recognition conditions were met.
Revenue Recognition on the Rendering of Services
When providing a service, many people can view the revenue recognition process as more complex than that of providing goods. In reality, the 2 cases are very similar.
All of the same recognition conditions that apply to the sale of goods also apply to the rendering of services. However there is one additional condition to be aware of:
The stage of completion of the transaction at the end of the reporting period can be measured reliably.
This one perhaps requires a bit more thought than the other conditions that must be met to recognise revenue.
When providing a service, your customers can’t necessarily see or touch the “product” you have sold to them. That is to say, you are not providing a tangible product to your customers.
Let’s take an example of a car wash. When a customer goes to a car wash, they leave with a clean car. You wouldn’t really consider the “cleanliness” of a car to be a product so what the customer is really paying for is the car wash attendant’s time that was spent cleaning the car and maybe the experience of the car wash attendant in the hope that they can do a better and faster job than if they washed the car themselves.
It is pretty obvious to the customer whether the job is finished or not as they will be able to see this. The attendant notifies the customer that the job is finished, the customer may have a check over the car to make sure the job is done and then hand over the cash and drive away.
In this case, the service is complete and the revenue can be recognised. It is easy to measure the completion of this type of service as a customer is not going to leave with the job half complete.
However, this may not always be the case.
There are many service providing businesses that offer services that aren’t as clear cut as the above example.
Service providers such as personal trainers, consultants, lawyers etc. may have agreements to provide a service for a number of weeks or until an end goal is reached.
In this case, the contract/agreement held with their customers would have to be reviewed in order to understand the revenue recognition point.
Revenue can only be recognised on the amount of the service that is completed at the end of a period/financial year.
Summary
In summary, revenue can be recognised for goods/services when:
- The goods have been provided – or the service is complete
- The amount of revenue can be reliably measured
- It is likely that the customer is going to pay for the goods/services
Related Posts
If you found this post helpful, you may want to check out some of our other topics related to the income statement which include:
This post is part of our “ultimate guide to income statements” series where we look at each item on the income statement in detail, aiming to help anyone to get a better understanding of a company’s financial statements.