The age-old maxim "Don't count your chickens before they're hatched," finds its manifestation in accounting principles such as the revenue recognition principle. Read on for an explanation and examples of this principle.
Revenue is the measurable amount charged to customers for goods delivered or services provided to them.
The revenue recognition principle is the accounting rule under the generally accepted accounting practices (GAAP). The revenue recognition principle in GAAP holds that revenue be recorded only under specific conditions such as when the amount of revenue is measurable, when a specific critical event in the revenue generation process has occurred and the process substantially completed, or an exchange has taken place.
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Types of Revenue Transactions
The principle of revenue recognition recognizes four types of revenue transactions as revenue. They are:
- Revenue from selling products on the date of sale or date of delivery.
- Revenue from services at the completion of services and when billable.
Revenue from the use of an enterprise’s assets by others at the end of the stipulated time, or when the asset is used up.
- Revenue from disposal of assets other than inventory at the point of sale as a gain or loss.
Recognizing Cash Inflows as Revenue
The revenue recognition principle recognizes cash inflows arising from revenue transactions as revenue only in three scenarios. These three revenue recognition methods are:
- Revenue earned following the substantial completion of a process undertaken to earn cash. Revenue recognition principles consider cash inflows as revenue not on executing a sales agreement, but only when the title to the completed goods or services passes to the customer, and the customer gets the legal right of ownership to the goods or services. An exception is long-term contracts that take time to complete. In such cases, payment at various intervals during a large project finds inclusion as revenue.
- The revenue is realized by the exchange of goods and services for cash or claims to cash. In normal situations, delivery of the product is enough to recognize the payment received as revenue, but if the business has a very high rate of product returns, the business can recognize the cash inflow as revenue only after the return period expires.
- The revenue is realizable when the assets received are convertible into a known amount of cash. A notable exception is for agricultural products and minerals where there is a ready market with reasonably assured prices, where the units are interchangeable, and selling and distributing does not involve significant costs. In such scenarios, the time of harvest or time of taking possession of the mineral becomes the critical point to count the asset as revenues.
Cash received but which does not fall under the above three conditions is recorded not as a revenue but as a liability, and shifts to earnings only after any of the three scenarios apply.
Examples of unearned revenue following such principles include advance rent received, security deposits received, customer down payments, advance payment for cost of labor or supplies, and the like.
Revenue recognition is an important principle in accrual accounting, and helps determine the accounting period to record the earnings.
Failure to adhere to the revenue recognition principle creates distortion in the company balance sheets. For instance, a company having a bad year in sales can mask this fact by including as revenue cash inflows that may be a refundable upfront security deposit for the possible execution of the work at a future date. The principle of revenue recognition places this cash inflow on the liability side instead of earnings, and allows considering it as revenue not on the execution of agreement, but on completion of the stipulated work.
Failure to follow such standards also creates situations such as having recorded revenue when the transaction fails to complete and the amount received must be refunded or adjusted in the accounting books.
- Kieso, Weygandt, and Warfield. "Intermediate Accounting 11th ed. Chapter 18: Revenue Recognition." Retrieved from www.cbe.uidaho.edu on 5 November 2010. [PPT]
- Revsine, Lawrence. (2002). "Financial Reporting & Analysis." Prentice Hall, ISBN 9780130323514