Accounting Standard 9 (AS 9) is concerned with premises on the basis of which revenue is recognized in the statement of profit and loss of a business entity. This accounting standard deals with the recognition of revenue arising in the course of ordinary activities of the enterprise. Such a revenue stems from:
- Sale of goods
- Rendering of services
- Use of business entity resources by others giving interest, royalties and dividends in return
However, this accounting standard does not deal with revenues resulting from:
- construction contracts
- hire purchase or lease agreements
- government grants and other such subsidies
- insurance contracts in case of insurance companies
So before we have a look at different provisions pertaining to revenue recognition, let’s first understand the meaning of revenue.[/vc_column_text]
What is Revenue?
Revenue refers to the total inflow of cash, receivables or other consideration resulting in the course of ordinary activities of a business entity. Such ordinary activities include:
- sale of goods
- rendering of services and
- use of business entity’s resources by others that yield interest, royalties and dividends
Thus, a business entity can measure revenue in terms of the amount charged to the customers for (i) supplying goods,(ii) providing services and (iii) granting them the facility to use entity’s resources.
However, the revenue in case of an agency is the amount of commission charged from customers. It need not consider the total inflow of cash, receivables and other consideration to measure its revenue.
So, the concept of revenue recognition is basically concerned with the time when a business entity recognizes its revenue in the statement of profit and loss.
Furthermore, the agreement between the parties involved in a transaction determines the amount of revenue that will result from such a transaction.
And any uncertainties regarding the determination of such an amount and its related costs may have an impact on the timing of revenue recognition. Therefore, to understand the concept behind revenue recognition, we need to consider the following three elements of revenue separately:
- Sale of goods
- Rendering of services
- Use of business entity’s resources by others yielding interest, royalties and dividends
1. Sale of Goods
Revenue Recognition in Case of Sale of Goods – Normal Case
Transfer of property by the seller to buyer is the basic criteria to determine the timing of revenue recognition in the case of a transaction involving sale of goods. Now, there can be two circumstances under transfer of property in case of goods.
The first case deals with the one where transfer of property in goods and the associated risks and ownership rewards to the buyer occur simultaneously. In such cases, the revenue is recognized at the time of sale of goods. This is because both the transfer of property in goods as well as risk and ownership rewards to the buyer take place at the same time.
The second case deals with the circumstances where transfer OF property in goods and significant risk and ownership rewards are not transferred to the buyer at the same time.
Thus, in such cases, revenue is recognized at the time when significant risks and ownership rewards are transferred to the buyer. These situations may occur due to a delay on account of either the buyer’s or seller’s fault.
Furthermore, the goods are at the risk of the party who has committed such a fault. Also, such a fault leads to a loss which may not have occurred otherwise.
Revenue Recognition in Case of Sale of Goods – Special Case
There are certain industries where the performance of an act or a number of acts are completed before the transaction generating revenue is executed.
For example, farmers harvest agricultural crops before selling them in the market. Furthermore, the sale of goods in such a case is assured either:
- under a forward contract or
- government guarantee or
- through an existing market for the goods where there is negligible risk of failure to sell
Thus, in such cases, the goods are valued at the net realisable value. The amount arising from such sales are not defined revenue as per this accounting standard. However, such amounts are appropriately recognized in the statement of profit and loss sometimes.
2. Rendering of Services
There are two methods to recognize revenues arising from service transactions.
Proportionate Completion Method
Under this method, performance includes execution of more than one act. Thus, revenue is recognized proportionately based on the performance of each of the acts.
Furthermore, the amount of revenue to be recognized is based on the contract value, associated costs, number of acts performed or any other suitable basis.
However, there can be cases where an indefinite number of acts have to be performed in order to provide service over a specific period of time.
In such cases, revenue is recognized on a straight line basis over the specific period. One even has the leeway to use some better method if the entity believes that there exists one.
Completed Service Contract Method
Under this method, performance includes execution of a single act.
However, there can be cases where more than a single act is performed to provide a service. And the services yet to be performed in the transaction are so significant as a whole that performance cannot be considered as completed unless those acts are executed.
In all such cases, completed service contract method is quite appropriate to recognize revenue. Under such a method, revenue is recognized when the single or final act takes place and where such a service as a whole becomes chargeable.
3. Interest, Royalties and Dividends
When others use entity’s resources it gives rise to:
These are the charges for using entity’s cash resources. It also includes any amounts due to the entreprise. Such accumulated amounts of interest are determined on the basis of time period for which it is outstanding and the rate of interest applicable.
This means that royalties are recognized on the basis of the terms of such an agreement. However, one even has the leeway to use some better method if the entity believes that there exists one.
Dividends are the rewards given on account of holding of investments in entity’s shares. Thus, dividends from investment in shares are not recognized in profit and loss statement unless a right to receive such a payment is given.
However, there can be cases when permission is required on interest, royalties and dividends from foreign countries. Furthermore, an uncertainty is expected in case of such remittance. In such cases, one needs to postpone revenue recognition.
Effect of Uncertainties in Revenue Recognition
The two most important parameters that are considered in case of recognition of revenue are:
- Revenue must be measurable
- It is not irrational to expect revenue collection at the time of sale or rendering of service
However, there are cases where it is not possible to assess final collection of revenue with reasonable certainty at the time of making any claim. Such a claim may include asking for a price hike, export incentives etc.
In such cases, you need to postpone the revenue recognition to an extent of the uncertainty involved. Furthermore, you need to recognize revenue only when you’re reasonably certain about the time when final collection of revenue will be made.
However, if there is no uncertainty involved with regards to the final collection of revenue, you must recognize revenue at the time of sale or rendering of service. This is despite the fact that payments in such a transaction are made by installments.
The, there are cases when uncertainty arises after the time of sale or rendering of service. In such cases, it is suggested to create a separate provision that reflects the uncertainty. There is no need to adjust the amount of revenue with the amount of uncertainty.