Recognition is the process of formally incorporating an item into the financial statements of an entity. Earnings is the most important item presented on the financial statements, and is determined from the revenues and expenses recognized in the period. The revenue recognition period tells us which period we should recognize revenue in. Together, the revenue recognition principle and the matching principle, which tells us what period expenses should be recognized in, are used to determine a company's earnings. The revenue recognition principle only applies to accrual-basis accounting.
The criteria, conventions and rules for recognition require that revenues are to be recognized when they are both realized, or realizable as well as earned.1 According to the SEC, this usually does not occur until four conditions are met:
1. The price is fixed or determinable
2. There is persuasive evidence that an arrangement exists
3. Collection can be reasonably assured
4. Substantial performance has been completed.2
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1. The price is fixed or determinable:
A fixed price is one that has been established and not subject to change or variation. A determinable price is the price that the buyer and seller are capable of settling or deciding on - for example, the market price of readily realizable assets such as marektable securities, precious medals or some agricultural products.3 An arrangement that includes a customer cancellation clause might indicate that the sale isn't final, or is merely part of a demonstration period. Revenue from a contract isn't fixed or determinable until the cancellation priveleges elapse. Short-term rights-of-return for products are not cancellation clauses, and can be recognized if returns can be reasonably estimated.
2. There is persuasive evidence that an arrangement exists:
Sales can't be recognized until the terms of a business deal or contract are agreed upon and finalized. Evidence may be in the form of a written sales agreement or written or electronic evidence such as a purchase order or online authorization.
3. Collection can be reasonably assured:
Collection can be reasonably assured refers to realized or realizable revenues. Revenues are realized when goods or services are exchanged for cash or claims to cash. Revenues are realizable if the assets received or held can be readily converted into cash or claims to cash. Assets are readily convertible if they can be sold or interchanged in an active market at prices that are readily determinable and there is no significant additional cost.
4. Substantial performance has been completed:
Substantial performance typically means that, when the earnings process is discrete, the service has been provided or the goods have been delivered and the risks and rewards of ownership must have transferred to the buyer. If the earnings process is continuous, and has more than one significant event, revenue recognition becomes more difficult. In many cases, revenue is is recognized over time, as is the case with long term construction projects.
1. FASB ASC 605-10-25-1
2. FASB ASC 605-10-S25
3. FASB CON5 par 84-d