What Is the Revenue Recognition Principle?

By Danny Wong

For company officers and managers who don’t directly perform accounting functions, the revenue recognition principle definition may seem like it has little impact on their duties. In reality, revenue recognition and the accounting principles behind it hold important implications for the short- and long-term viability of companies, and how they will handle operations such as sales, expense management, collections, and more.

The Basics of the Revenue Recognition Principle

When a company makes a sale, the revenue earned from that sale has to be recorded so that it will be reflected on the income statement. This raises the question of when that revenue should be recognized. To answer that question, the revenue recognition principle states that certain conditions must be met before a company can record the revenue from a sale — essentially, when it can be counted as “earned.”

The revenue recognition principle is an important component of the accrual basis of accounting, and it is outlined as a part of the Generally Accepted Accounting Principles (GAAP). Recently, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) outlined a new set of guidelines relating to revenue recognition in an attempt to eliminate inconsistencies (especially among different industries whose companies sell vastly different products and services) and provide a stronger framework to guide businesses in their accrual accounting. In order to complete the process of revenue recognition, you must perform the following five steps:

  1. Enter into a contract with a customer

  2. Agree on the obligations of the company as part of the contract

  3. Agree on the price of the transaction

  4. Allocate the price to the obligations

  5. Satisfy the obligations outlined in the contract and record the revenue appropriately

It’s important to note that there is nothing in these five criteria about receiving payment for the goods or services provided. We’ll delve more deeply into the reasons a little later, but in this regard the accrual basis of accounting is different from the cash basis of accounting, which stipulates that revenue is recognized once a cash payment is received.

How Revenue Recognition Affects Every Department of a Company

Typically, employees who aren’t directly involved with accounting functions pay very little attention to those functions. Some sales managers and representatives, for example, put all of their focus on getting the “yes” from the client, and don’t feel the need to concern themselves with what happens after that. But how the revenue from that sale is recognized is very important, not just to the sales and finance teams, but to every employee and stakeholder in the company.

The revenue recognition principle contains ripple effects that touch every corner of a business. When revenue is recognized in an accurate and timely fashion, the income statement shows a true picture of the company’s financial health in real time. If too much or too little revenue is recognized during a specific accounting period, it may impact a company’s ability to budget for various departments. If too much revenue is recorded, for example, a department may think it has more money to work with than it does and end up overspending and putting the company in a precarious cash flow position. If a company ends up collecting more cash than expected due to under-recognized revenue, then it may miss out on additional resources that could have been used to help the company grow even faster.

Total revenue is also one of the most important considerations for financial analysts when they evaluate the health of a company. Analysts make valuations, based partly on total revenue, that could have wide-ranging effects for an organization, affecting its stock price, its ability to secure investment funds, its merger and acquisition potential, its borrowing ability, and more.

How Revenue Recognized Differs from Cash Collected, and How They Are Linked Together

One of the most common mistakes made by people unfamiliar with the accrual basis of accounting is conflating revenue earned and recognized with cash payments collected. Let’s say you sell a software program, and you have just secured a contract to supply a new program to every user of a massive Fortune 500 client.

Since this is such an important account for your growing business and the client has been established for decades, you extend them net-60 payment terms. As soon as the installation of the program is complete, you have satisfied all of the criteria for revenue recognition under the accrual basis of accounting. You record all of the revenue from the contract then, even though you might not receive cash from the client until the following quarter.

Conversely, once you sign a contract with a client, you might receive a cash deposit before the work has actually begun. Although you have a payment on the books, you shouldn’t recognize any revenue for the job yet because your obligations have not been fulfilled. In this case, you would have to list the cash deposit as a liability, which will be offset by the revenue once the work has been performed.

When following the revenue recognition principle, it’s crucial to plan for revenue that you may not be able to collect. This issue affects every company differently; some companies are able to collect 100% of their recognized revenue, while others struggle significantly with collecting. If payment for the full amount of the revenue is in doubt, then the accounts receivable team should note the outstanding portion of the revenue in an allowance for doubtful accounts in order to lower the amount of accounts receivable on the balance sheet. In cases where there is an existing reason to suspect that none of the payment will be collected, then you should refrain from recognizing revenue unless a payment is received.

Different Methods for Revenue Recognition

Revenue recognition comes in many different forms to fit many different types of businesses. Real estate agents operate a very different business model from clothing retailers, so it makes sense that companies would differ in how they ultimately record their revenue. No matter which method a company chooses to employ, the revenue recognition principle requires that the same guidelines are satisfied. Some of the most common revenue recognition methods include:

  • Sales-based method. In this format, all of the revenue for a sale is recognized when both parties agree to the terms of the sale. This method is typically used for companies that sell a product that has been pre-produced. In other words, there is no required work taking place after the sale, only a transfer of title. Therefore, the revenue generation process has already occurred and is satisfied upon execution of the contract.

  • Installment method. For some companies, it is doubtful that they will receive the full payment for a sale at the time the service is rendered. In these cases, they may choose to record the revenue in installments as they expect to receive cash payments.

  • Completed-contract method. This is a typical method you would find in a software company that mostly works in short-term implementations. For this method, all of the revenue for a specific project is recorded upon completion of that project.

  • Percentage-of-completion method. For contracts that span long periods of time, such as in the construction industry, using the completed-contract method may be logistically unfavorable. Companies then turn to the percentage-of-completion method, where they use certain formulas to estimate the amount of revenue that has been earned during a time period based on the work done and the expenses incurred.

Closing Thoughts

It is important for employees at companies of all sizes to understand the revenue recognition principle. This understanding provides them with a holistic view of their business’ financial situation. It also helps them appreciate the implications of their actions, whether they are responsible for the closing of a sale or the fulfillment of it.
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