Abstract
Revenue recognition principle is widely used in determining revenue to be included in calculation of income of any given financial year. The method has several merits and demerits which have drawn appreciation and criticism among accountants and users of financial statements. The strengths of this method e.g. its ability to provide the true amount of revenue attributable to a given financial year has made many small and large firms to rely on it in preparing trading profit and loss account. Despite its main weakness which is failure to give clear guidelines in determining the value of doubtful debts to be factored in calculating realizable income the method popularity is expected to continue in future.
Knowing when to recognize revenue is an important aspect of good accounting in all organizations. Revenue recognition principle provides clear guideline on when either revenue or expense should be recognized. The principle stipulates that revenue should only be recognized when earned but not when money is received. While, expense are recognized when incurred but, not when money has been paid. This paper examines the strength and weaknesses of revenue recognition principle as a basis of accrual accounting and finally provides probable direction on future use of the method.
Various financial statements have shown that several international companies have used revenue recognition principle as a basis of determining profit earned. This is proven by associating expenses of a given period to the income of the period. For example, the shell company which uses this method has show the following as the value of goodwill at the end of year 2011.
Amortization since acquisition (117)
Charge for the year 2011 (3)
Value as at 31st Dec 2011 20
The charge for the year is included in calculating profit for the year 2011. This is because it reflects the impairment of good will in the2011 financial year. Note five to financial stament shows that all the expenses regarding depreciation of tangible assets or impairment of intangible assets have been included in calculating net profit irrespective of there being no money which has been paid. Below is part of the note showing inclusion of expenses on tangible and intangible assets in calculating income for year 2011.
NOTES TO THE PROFIT ANDLOSS ACCOUNT
2011
Profit on ordinary activities before tax is stated after charging/(crediting):
Depreciation - owned assets 12,067
Amortization of trademarks 34
Depreciation - leased assets 323
Amortization of programming rights 870
Amortization of video stream assets 8,922
In regard to income recognition, all income receivable are added in determining the net income for the years. This income is added despite the fact that respective money was to be received at a later date. This is demonstrated by note number 7 (shell, 2007)
Other interest receivable and similar income
Bank deposit and government bond interest 349 360
Other interest receivable 113 288
Joint venture interest receivable 1
The revenue recognition principle has several advantages which has made it admirable to accountants over years. First and foremost, it makes sure that all incomes earned in a trading period are included in determining net profit. Secondly, it avoids inclusion of any income received which may not yet be earned. This makes sure that total income quoted in financial statement reflects the true amount attributable to the financial year. Finally, it provides the basis of recognizing expenses with respective income. This avoids understating expenses of a given period with a view of overstating profit earned (Magoon, 2008).
On the other hand, this method has several demerits. Firstly, some income earned but, respective money has not been received may never be paid by debtors. Secondly, the provision for doubtful debts which is included to counter the disadvantage of bad debts may either be understated or overstated (Harrison, & Horngren, 2001).
Revenue recognition principle ensures that all income earned is included in calculation of net profit for a given financial year. The method is universally accepted despite a few weaknesses associated with it because it is seen as basis of preparing true and fair financial statements. It is likely that accountants will continue to use the principle in future and users of financial statements will appreciate its contribution in ensuring financial statements reflect the true financial position of businesses.
References
Harrison, W. T., & Horngren, C. T. (2001). Financial accounting (4th ed.). Upper Saddle River, NJ: Prentice Hall
Magoon, L. M. (2008). Dictionary of financial formulas and ratios. London: Global Professional Shell, 2011. Financial Report. Available at:
http://www.shell.com/home/content/src/investor_information/annual_reports/
(accessed on 8th dec, 2012)
