In this post, we’ll talk about every business owner’s favourite account – revenues!
All jokes aside, revenues are an extremely important line on your statement of profit or loss and are often first to be examined by readers of the financial statements. For that reason, it is extremely important revenues are recognized appropriately and in line with accounting standards.
Under international financial reporting standards (IFRS), we look at IFRS 15: Revenue from Contracts with Customers for any guidance relating to revenues. This section recently replaced IAS 18: Revenue but many of the same underlying principles remain the same.
This post will focus on one of the key questions about revenue – when do we record it? We’ll take a dive into IFRS 15, which clearly states that 5 criteria must be met to record (also called recognize) revenue. Below, we’ve listed the criteria and in italics we explain what that means to the average person:
- The parties to the contract have approved the contract (in writing, orally or in accordance with other customary business practices) and are committed to perform their respective obligations.
What does this mean? All companies or people involved in the contract have agreed to it and will complete their part of the contract. This could be in writing, but doesn’t have to be. It can be an oral agreement or even something like a hand-shake is enough, as long as these are considered normal business practice.
- The entity can identify each party’s rights regarding the goods or services to be transferred.
What does this mean? You can clearly distinguish who must do what based on the contract. You must be able to clearly identify who has which responsibilities.
- The entity can identify the payment terms for the goods or services to be transferred.
What does this mean? It is clear what the payment terms are, i.e. how much will be paid, in what currency, when, and how.
- The contract has commercial substance (i.e. the risk, timing or amount of the entity’s future cash flows is expected to change as a result of the contract)
What does this mean? The contract has a financial impact on the companies or people involved. The contract should result in a change in the company’s resources or claims to those resources. For example, the contract would provide cash to one company, in exchange for a good delivered to the other company in the contract.
- It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.
What does this mean? It is likely that the company will actually collect what the other party in the transaction owes them. For example, if your company sells a good to another company who has just filed for bankruptcy, it is not likely your company will collect the cash owed and so this criterion would not be met.
Remember, the standard states that ALL of the 5 criteria need to be met. Even if 4 of the 5 have been met, but one hasn’t been, you cannot record revenue!
As an accountant, we sometimes only focus on numbers, but a large part of your job as you progress through your career will be to analyze accounting standards and apply them to your company’s transactions. Although many IFRS or US GAAP standards may seem daunting, when you break them down piece by piece like we’ve done here, they become much clearer.
Any other accounting standards you want us to dive into? Let us know in the comments below!