Revenue Recognition

The Revenue Recognition principle is a cornerstone of accrual accounting together with matching principle. They both determine the accounting period, in which revenues are recognized. According to this principle, revenues are recognized when they are 1) Realized or realizable, and2) Earned (usually when goods are transferred or rendered). In cash accounting, revenues are recognized when cash is received no matter when goods or services are sold.

Cash can be received in an earlier or later period than obligations are met and related revenues are recognized that results in the following two types of accounts: accrued revenue, revenue is recognized before cash is received and deferred revenue, revenue is recognized after cash is received.

Principle of Revenue Recognition

The revenue recognition principle states that, under the accrual basis of accounting, you should only record revenue when an entity has substantially completed a revenue generation process. Thus you record when it has been earned. Also under the accrual basis of accounting, if an entity receives payment in advance from a customer, then the entity records this payment as a liability and not as revenue. Only after it has completed all work under the arrangement with the customer it can recognize the payment as revenue. Under the cash basis of accounting you should record revenue when a cash payment has been received.

 Types of Revenue Recognition

There are 4 types of revenue which must be recorded as stated in the principles of Revenue recognition. First is the Revenues from selling inventory are recognized at the date of sale often interpreted as the date of delivery. The second type is the Revenues from rendering services are recognized when services are completed and billed. The third type is the Revenues from permission to use the company’s asset is recognized as time passes or as assets used. Fourth is the Revenue from selling an asset other than inventory is recognized at the point of sale, when trade takes place.

Exceptions

Revenues not recognized at sale

The general rule says that revenue from selling inventory is recognized at the point of sale, but there are several exceptions like buyback agreements and returns. Buyback agreement means that a company sells a product and agrees to buy it back after some time.

Revenues recognized before sale

This exception primarily deals with long- term contracts such as construction, development of aircraft, weapons and space exploration hardware.

Revenues recognized after sale

Installment Sales method, Cost Recovery method and Deposit Method are the 3 methods in which there is a high degree of uncertainty regarding collectability of revenue.

Questions:

• What is Revenue Recognition?
• What are the types of Revenue Recognition?