Revenue recognition
Encyclopedia
The revenue recognition principle is a cornerstone of accrual accounting together with matching principle
. They both determine the accounting period
, in which revenues and expenses are recognized. According to the principle, revenues are recognized when they are realised or realisable, and are earned (usually when goods are transferred or services rendered), no matter when cash is received. In cash accounting – in contrast – 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 (when goods or services are delivered) and related revenues are recognized that results in the following two types of accounts:
are not recognized as revenues, but as liabilities (deferred income
), until the conditions (1.) and (2.) are met.
Recognition of revenue from four types of transactions:
In practice, this means that revenue is recognized when an invoice has been sent.
item is recognized, while cash for them is to be received in a latter accounting period
, when its amount is deducted from accrued revenues. It shares characteristics with deferred expense (or prepaid expense, or prepayment) with the difference that an asset to be covered later is cash paid out to a counterpart for goods or services to be received in a latter period when the obligation to pay is actually incurred, the related expense
item is recognized, and the same amount is deducted from prepayments
Deferred revenue (or deferred income) is a liability, such as cash received from a counterpart for goods or services which are to be delivered in a later accounting period
, when such income item is earned, the related revenue
item is recognized, and the deferred revenue is reduced. It shares characteristics with accrued expense with the difference that a liability to be covered later is an obligation to pay for goods or services received solo from a counterpart, while cash for them is to be paid out in a later period when its amount is deducted from accrued expenses.
For example, a company receives an annual software license fee paid out by a customer upfront on the January 1. However the company's fiscal year ends on May 31. So, the company using accrual accounting adds only five months worth (5/12) of the fee to its revenues in profit and loss
for the fiscal year the fee was received. The rest is added to deferred income
(liability) on the balance sheet
for that year.
are not considered to be a sufficient evidence of sale, thus no revenue is recorded until the sale is completed. Advances are considered a deferred income
and are recorded as liabilities until the whole price is paid and the delivery made (i.e. matching
obligations are incurred).
is recognized at the point of sale, but there are several exceptions.
Matching principle
The matching principle is a culmination of accrual accounting and the revenue recognition principle. They both determine the accounting period, in which revenues and expenses are recognized. According to the principle, expenses are recognized when obligations are incurred The matching principle...
. They both determine the accounting period
Accounting period
An accounting period is a period with reference to which United Kingdom corporation tax is charged. It helps dictate when tax is paid on income and gains...
, in which revenues and expenses are recognized. According to the principle, revenues are recognized when they are realised or realisable, and are earned (usually when goods are transferred or services rendered), no matter when cash is received. In cash accounting – in contrast – 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 (when goods or services are delivered) and related revenues are recognized that results in the following two types of accounts:
- Accrued revenue: Revenue is recognized before cash is received.
- Deferred revenue: Revenue is recognized after cash is received.
General rule
Received advancesAdvance payment
An advance payment, or simply an advance, is the part of a contractually due sum that is paid in advance for goods or services, while the balance included in the invoice will only follow the delivery. It is called a prepaid expense in accrual accounting.-See also:*Advance against royalties*Pay or...
are not recognized as revenues, but as liabilities (deferred income
Deferred income
Deferred income is, in accrual accounting, money received for goods or services which have not yet been delivered...
), until the conditions (1.) and (2.) are met.
- Revenues are realized when cash or claims to cash (receivable) are received in exchange for goods or services. Revenues are realizable when assets received in such exchange are readily convertible to cash or claim to cash.
- Revenues are earned when such goods/services are transferred/rendered. Both, such payment assurance and final delivery completion (with a provision for returns, warranty claims, etc.), are required for revenue recognition.
Recognition of revenue from four types of transactions:
- Revenues from selling inventoryInventoryInventory means a list compiled for some formal purpose, such as the details of an estate going to probate, or the contents of a house let furnished. This remains the prime meaning in British English...
are recognized at the date of sale often interpreted as the date of delivery. - Revenues from rendering services are recognized when services are completed and billed.
- Revenue from permission to use company’s assets (e.g. interests for using money, rent for using fixed assets, and royalties for using intangible assets) is recognized as time passes or as assets are used.
- Revenue from selling an asset other than inventory is recognized at the point of salePoint of salePoint of sale or checkout is the location where a transaction occurs...
, when it takes place.
In practice, this means that revenue is recognized when an invoice has been sent.
Revenue vs. cash timing
Accrued revenue (or accrued assets) is an asset such as proceeds from a delivery of goods or services, at which such income item is earned and the related revenueRevenue
In business, revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. In many countries, such as the United Kingdom, revenue is referred to as turnover....
item is recognized, while cash for them is to be received in a latter accounting period
Accounting period
An accounting period is a period with reference to which United Kingdom corporation tax is charged. It helps dictate when tax is paid on income and gains...
, when its amount is deducted from accrued revenues. It shares characteristics with deferred expense (or prepaid expense, or prepayment) with the difference that an asset to be covered later is cash paid out to a counterpart for goods or services to be received in a latter period when the obligation to pay is actually incurred, the related expense
Expense
In common usage, an expense or expenditure is an outflow of money to another person or group to pay for an item or service, or for a category of costs. For a tenant, rent is an expense. For students or parents, tuition is an expense. Buying food, clothing, furniture or an automobile is often...
item is recognized, and the same amount is deducted from prepayments
Deferred revenue (or deferred income) is a liability, such as cash received from a counterpart for goods or services which are to be delivered in a later accounting period
Accounting period
An accounting period is a period with reference to which United Kingdom corporation tax is charged. It helps dictate when tax is paid on income and gains...
, when such income item is earned, the related revenue
Revenue
In business, revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. In many countries, such as the United Kingdom, revenue is referred to as turnover....
item is recognized, and the deferred revenue is reduced. It shares characteristics with accrued expense with the difference that a liability to be covered later is an obligation to pay for goods or services received solo from a counterpart, while cash for them is to be paid out in a later period when its amount is deducted from accrued expenses.
For example, a company receives an annual software license fee paid out by a customer upfront on the January 1. However the company's fiscal year ends on May 31. So, the company using accrual accounting adds only five months worth (5/12) of the fee to its revenues in profit and loss
Profit and Loss
Profit and Loss may refer to:* Profit & Loss, monthly business magazine founded in July 1999 especializing in Foreign exchange market and derivative markets...
for the fiscal year the fee was received. The rest is added to deferred income
Deferred income
Deferred income is, in accrual accounting, money received for goods or services which have not yet been delivered...
(liability) on the balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
for that year.
Advances
AdvancesAdvance payment
An advance payment, or simply an advance, is the part of a contractually due sum that is paid in advance for goods or services, while the balance included in the invoice will only follow the delivery. It is called a prepaid expense in accrual accounting.-See also:*Advance against royalties*Pay or...
are not considered to be a sufficient evidence of sale, thus no revenue is recorded until the sale is completed. Advances are considered a deferred income
Deferred income
Deferred income is, in accrual accounting, money received for goods or services which have not yet been delivered...
and are recorded as liabilities until the whole price is paid and the delivery made (i.e. matching
Matching principle
The matching principle is a culmination of accrual accounting and the revenue recognition principle. They both determine the accounting period, in which revenues and expenses are recognized. According to the principle, expenses are recognized when obligations are incurred The matching principle...
obligations are incurred).
Revenues not recognized at sale
The rule says that revenue from selling inventoryInventory
Inventory means a list compiled for some formal purpose, such as the details of an estate going to probate, or the contents of a house let furnished. This remains the prime meaning in British English...
is recognized at the point of sale, but there are several exceptions.
- Buyback agreements: buyback agreement means that a company sells a product and agrees to buy it back after some time. If buyback price covers all costs of the inventory plus related holding costs, the inventory remains on the seller’s books. In plain: there was no sale.
- ReturnsReturningIn retail, returning is the process of a customer taking previously purchased merchandise back to the retailer, and in turn, receiving a cash refund, exchange for another item , or a store credit...
: companies which cannot reasonably estimate the amount of future returns and/or have extremely high rates of returns should recognize revenues only when the right to return expires. Those companies which can estimate the number of future returns and have a relatively small return rate can recognize revenues at the point of sale, but must deduct estimated future returns.
Long-term contracts
This exception primarily deals with long-term contracts such as constructions (buildings, stadiums, bridges, highways, etc.), development of aircraft, weapons, and space exploration hardware. Such contracts must allow the builder (seller) to bill the purchaser at various parts of the project (e.g. every 10 miles of road built).- Percentage-of-completion methodPercentage-of-Completion methodPercentage of completion is an accounting method of work-in-progress evaluation, for recording long-term contracts. For such tasks, this is the only method authorized by the International Financial Reporting Standards ....
says that if the contract clearly specifies the price and payment options with transfer of ownership, the buyer is expected to pay the whole amount and the seller is expected to complete the project, then revenues, costs, and gross profitGross profitIn accounting, gross profit or sales profit is the difference between revenue and the cost of making a product or providing a service, before deducting overhead, payroll, taxation, and interest payments...
can be recognized each period based upon the progress of construction (that is, percentage of completion). For example, if during the year, 25% of the building was completed, the builder can recognize 25% of the expected total profit on the contract. This method is preferred. However, expected loss should be recognized fully and immediately due to conservatism constraint. - Completed contract method should be used only if percentage-of-completion is not applicable or the contract involves extremely high risks. Under this method, revenues, costs, and gross profit are recognized only after the project is fully completed. Thus, if a company is working only on one project, its income statement will show $0 revenues and $0 construction-related costs until the final year. However, expected loss should be recognized fully and immediately due to conservatism constraint.
Completion of production basis
This method allows recognizing revenues even if no sale was made. This applies to agricultural products and minerals because there is a ready market for these products with reasonably assured prices, the units are interchangeable, and selling and distributing does not involve significant costs.Revenues recognized after Sale
Sometimes, the collection of receivables involves a high level of risk. If there is a high degree of uncertainty regarding collectibility then a company must defer the recognition of revenue. There are three methods which deal with this situation:- Installment sales methodInstallment Sales MethodThe installment sales method is one of several approaches used to recognize revenue under the US GAAP, specifically when revenue and expense are recognized at the time of cash collection rather than at the time of sale...
allows recognizing income after the sale is made, and proportionately to the product of gross profit percentage and cash collected calculated. The unearned income is deferred and then recognized to income when cash is collected. For example, if a company collected 45% of total product price, it can recognize 45% of total profit on that product. - Cost recovery method is used when there is an extremely high probability of uncollectble payments. Under this method no profit is recognized until cash collections exceed the seller’s cost of the merchandise sold. For example, if a company sold a machine worth $10,000 for $15,000, it can start recording profit only when the buyer pays more than $10,000. In other words, for each dollar collected greater than $10,000 goes towards your anticipated gross profit of $5,000.
- Deposit method is used when the company receives cash before sufficient transfer of ownership occurs. Revenue is not recognized because the risks and rewards of ownership have not transferred to the buyer.
See also
- Generally accepted accounting principlesGenerally Accepted Accounting PrinciplesGenerally Accepted Accounting Principles refer to the standard framework of guidelines for financial accounting used in any given jurisdiction; generally known as accounting standards...
- Comparison of cash and accrual methods of accounting
- Vendor-specific objective evidence