Revenue Recognition Principle

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The revenue recognition principle states that a company should record and recognize revenue when it is earned and not when the actual cash proceeds are received.

This follows the accrual accounting concept which we have looked in a previous article.

For example, a lawn mowing business delivers its lawn mowing service to its customer, however, does not expect to receive payment until next month. The revenue recognition principle would dictate that this amount be treated as a revenue item for the current period.

Another variation of this example is that the same lawn mowing business receives advance payment from a customer for a service to be delivered next month. Even though the cash payment has been received, the transaction would not yet be treated as a sale and would be recorded as unearned revenue.

Requirements for Revenue Recognition

One of the requirements for using revenue recognition is that the company must have a double-entry bookkeeping system in place. There are some guidelines and conditions for implementing the revenue recognition principle:

  • An agreement should be in place between the company and its customer: This means that verbal promises do not fit the bill for revenue recognition. For instance, if a customer promises a company to buy a piece of equipment from it next month, the company cannot record this transaction as a sale since it is only a verbal contract.

Another example is of a consulting firm that sends an invoice to the client for its services, with credit terms of 30 days. If the client accepts the terms and agrees to pay within the stipulated time, the company can go ahead and record the transaction as a sale.

  • The product or service has been delivered or completed: This is one of the most important concepts of the revenue recognition principle. If the product or service has not been delivered, it should instead be recorded as an “unearned revenue”.
  • The cost has been determined: Prior to recognizing the revenue, the cost of the service or product must be disclosed or agreed upon with the client. If the amount is not determined yet, the transaction cannot be recorded as a sale.
  • The amount is also collectable from the client: If a client is not deemed creditworthy and is not expected to pay the amount as per the credit terms, then it should not be recognized as a sale. The company must consider delayed the recording of such revenue.
  • If the payment is received in advance, record revenue only when product or service has been delivered: If a company is offering laundry services and the customer pays in the advance amount of $2000 for the next 4 months. Then as per the revenue recognition principle, the company will need to realize only $500 in each of the next 4 accounting periods.

Steps in Revenue Recognition from Contracts

There are five major steps for revenue recognition:

Step 1 – Identifying the Contract

To form a contract, all the below conditions must be satisfied:

  • Both parties are aware of the contract
  • Both parties have approved the contract (whether it be written, verbal or implied).
  • The point of transfer of the goods or services is identifiable.
  • The payment terms are clearly disclosed and there is no confusion about it.
  • The contract should have commercial substance.
  • Collection of payment is highly likely.

Step 2 – Identifying the Performance Obligations

The benefit that the client is receiving from the contract is referred to as the performance obligation of the contract. There might be more than one performance obligation arising from the contract for a client.

Step 3 – Agreeing on the Transaction Price

The transaction price should be clear and easily determinable. Most contracts will have a fixed price but there can be variable contracts as well.  Fixed price would include a car driving lesion for a month costing $500. An example of a variable price contract would be a car rental company that charges $20 per hour. In both cases, the price of the contract is known and agreed upon by both parties.

Step 4 – Allocating Transaction Price to Performance Obligations

In case there is more than one performance obligation being delivered, the total contract price should be easily dividable into the amount of revenue arising from each obligation. For example, a total contract price of $ 100 charged by the car servicing company to its client can be broken down into $ 70 for the car wash and $ 30 for the oil change.

Step 5 – Recognizing Revenue with Performance

As previously stated in the conditions section, revenue can only be recognized for the performance obligation that has been delivered by the company to the client. For instance, a contract including a car sale and complimentary driving lesson for the customer would require analyzing the transaction in two parts.

The first performance obligation is the sale of the car, which has already been delivered by the company to the customer. The company will record part of the contract revenue arising from this performance obligation. It will debit cash or accounts receivable and it will credit revenue account with the appropriate amount.

The second performance obligation of the contract is the driving lesson that the company had promised the customer, but which has not yet been availed. Therefore, in other words, the delivery of this performance obligation is still pending on the company’s end. Therefore, the appropriate double entry to record this transaction would be to debit cash and credit deferred revenue.

Now suppose the client decides to avail the driving lesson after several weeks. The proper double entry to record this in the books would be to debit deferred revenue and credit the revenue account by the appropriate portion of the contract price.