Understanding the Revenue Recognition Process:

?What It Is and Why It Can Be Tricky

Revenue recognition is crucial for companies that follow accrual accounting. It’s all about making sure that revenue from customer contracts is accounted for correctly. IFRS 15, which is a key standard for this, gives companies a clear framework to follow. This ensures they stay compliant with audit rules and avoid any shady practices or errors that could misrepresent their earnings. The goal is to make sure financial statements are accurate and reflect the actual financial health of the business. IFRS 15 revenue recognition should be used by all entities that operate based on contracts with customers that should clearly state the deliverables along with their prices.

While revenue recognition may appear straightforward, it requires careful attention from financial analysts and accountants. They must consider the workflow, budgeting, and payment schedule associated with each customer contract to ensure compliance. According to acceptable standards, revenue should be recognized in the income statement during the period in which it is earned or realized. Realized revenue occurs when goods or services have been provided to the customer, though payment may be received at a later date. Earned revenue refers to the completion of an entity's obligations under a contract, where the service or product has been delivered. Conversely, unearned revenue arises when payment is received in advance for a product or service not yet provided. This advance payment is recorded as a liability until the obligation is fulfilled, at which point it is recognized as revenue on the income statement.

The IFRS 15 revenue recognition model consists of the below five steps that are used to make sure that processes are transparent, creditable, in line with the time, and generate economic efficiency.?        

1. Identifying the contract
2. Identifying separate performance obligations
3. Determining the transaction price
4. Allocating transaction price to performance obligations
5. Recognizing revenue when each performance obligation is satisfied

Entities will face a variety of common challenges during revenue recognition. The first issue comes when a contractual relationship is in force and the individual performance obligations may not be properly identified. Accurately determining the unique performance obligations is important as it has an impact on the timing of revenue recognition. This means that the finance and accounting team should have detailed knowledge of the performance obligations and deliverables of the contract. If the performance obligations are improperly identified the financial statements may have to be restated, which leads to time inefficiencies and problems with audit compliance.

Another problem that is faced and can arise is the incorrect treatment of contract modifications. Contract modifications are usual for long term projects and projects that are recurring, and they can cause confusion in:        

• timing of revenue recognition.
• transaction pricing of the deliverables
• timing of billing and payments from the customer

When a change in transaction price applies to an already satisfied performance obligation, the adjustment amount should be reflected as an increase or decrease in revenue, based on the appropriate time period when it took place. A modification in the contract is considered:        

• a separate contract
• a termination of an existing contract
• or an amendment to the existing contract

Knowledge on what to do with recognized revenue after a contract modification takes place is important because contract modifications can lead to credit notes to be issued to a customer, for example. Revenue might have already been recognized based on the original contract and the client may not end up paying for the deliverables and request a credit memo after the contract modification states a cancellation of some of the work. Hence it is important to state in the original contract very clearly the payment terms of deliverables and ensure that contract modifications will not mess up the process of already recognized revenue.?

A third common challenge that can arise during revenue recognition is that the entity providing the services must decide correctly based on the contract whether it is acting as:        

• the principal - full responsible for the quality and timeliness of the deliverables
• the agent - completes the work but does not bear responsibility for the quality and timely delivery of the deliverables

This is important because IFRS has different rules for principals and agents. Entities that use contractors or third party or outsourced labor must be attentive to ensure that they recognize revenue in accordance with their role in the contract. The entity is acting as a principle when it has signed the contract, and it maintains control over the goods and services that are to be delivered, even though the actual work is being performed by contractors. In this case the entity must recognize the gross revenue which is the total revenue from the deliverable. If the entity or a contractor is an agent, and it is not in control of the delivery of goods or services in the contract, only the net revenue must be recognized.

The three main indicators entities should use to help determine if they are the principal or agent are:        

• if they possess primary responsibility for fulfillment of the obligation?
• if they possess the inventory risks before or after transferring the deliverable to the client
• their discretion in establishing a price for the transaction.

At Prima Finance, revenue recognition is at the heart of our services. The vast knowledge of IFRS accounting standards of our experts ensures that you are at the right place at Prima Finance when it comes to consulting on recognizing revenue from contracts with customers.

Article by Tigran Israyelyan