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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
How Revenue Recognition Affects Every Department of a Company
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.