If you are looking for a simple yet helpful explanation to understand the revenue recognition principle, then you are at the right place. Here we have lifted up the curtains and made things crystal clear through the simplest of examples.
What is Revenue Recognition Principle?
If we look into the literal meaning of revenue recognition. “revenue” refers to the addition to capital, while “recognition” means to recognize. To recognize what? To recognize revenue. Revenue is generated either by sales or by providing services. So, when do you recognize revenue? What will be the time for recording the revenue? The answer to this question is that whenever the actual sale is happening regardless of whether you have received the cash or not. In other words, revenue is recognized when earned not when cash is received.
- Simply put, the revenue recognition principle states that revenue should recognize when the actual sale has been made (which means you deliver the goods or services to the customer) regardless of considering cash received or not.
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Let’s suppose you sell $50,000 goods in cash on 5th January. In this case, the revenue will be recognized on 5th January. But let’s assume you sell $30,000 goods on credit on 6th February. You received the payment on 18th February. Now the question arises that when to recognize the revenue? The answer is that revenue is recognized on 6th January. Moreover, it is evident that to recognize revenue, receiving cash is not taken into account. Likewise, the only thing that matter is that sale has happened.
A customer orders a cake from a bakery and pays in advance in November. The customer received the cake in the month of December. Under the revenue recognition principle, revenue is recognized when it’s earned, not when cash is received. So, in this case, the bakery recognizes its revenue not in the month of November, but in December because that is when the revenue is earned.
In accounting, we call this kind of income deferred revenue because the payment is made in advance for the goods that are to be delivered in the future.
Let’s have another simple revenue recognition principle example to have more better understanding. For instance, if a customer gets his car washed in February he pays the service in advance with 30-day payment terms which means paying cash in January. Under the principle, the revenue is recognized in February because that’s when the service was provided. That’s when the car wash took place. Similarly, in this case, we call revenue as accrued revenue because the service was provided in advance of the payment. Furthermore, it is important to understand that either it is accrued or deferred revenue both don’t exist under the cash basis of accounting. Finally, on a cash basis, revenue is recognized only when cash is received.
Let’s understand this principle with the help of a journal entry.
Revenue should be recognized when it is earned. If Cash has not been received against revenue, then accounts receivable should be recorded by debiting the accounts receivable and crediting the revenue account.
If a sale is on a cash basis, then the bank account is debited and the revenue account is credited by the amount of revenue received.
- 1. If goods are sold on 30 days of a credit term, and the value of sales is 5,000 dollars, then we should make the following journal entry to record the transaction.
- 2. If goods are sold in cash, and the value of sales is 5000 dollars, then we should make the following journal entry to record the transaction.
Revenue Recognition Accounting Standard
There are some standards that need to be followed to recognize revenue.
Revenue Recognition Principle (GAAP)
In order to recognize revenue, GAAP(Generally Accepted Accounting Principle) provides Accounting Standards Codification (ASC) 606 guidelines in collaboration with Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB).
There are some criteria to be fulfilled. There are some particular conditions in which revenue is recognized which are stated below.
- The ability to identify customer contracts.
- Identification of performance obligation in exchange for consideration received from the customer.
- Price of contract which customer has to pay against the services or goods.
- Allocation of the contract price to different stages of performance obligation in the contract with the customer.
- To record the revenue when the performance obligations are satisfied.
Revenue Recognition Principle (IFRS)
IFRS 15 is about revenue recognition, but it does not apply to the amount of revenue received as stated below.
- Lease contracts (IFRS 16)
- Insurance contracts
- Financial instruments
Revenue recognition principle IFRS 15 outlines some recognition criteria for revenue which are stated below:
Firstly, a contract could be identified between two parties, and it must have a kind of commercial substance.
The contract should not necessarily be in written form, it could be in verbal form, and it could also be implied, it is highly likely that amount of revenue will be received.
Secondly, Both parties should be able to identify the performance which is required to be performed by the seller against the amount of consideration.
Thirdly, the Transaction price should be identified and agreed upon.
Fourthly, We should be able to allocate the transaction price to different phases of performance obligation so that revenue could be recorded when each service is completed.
Most importantly, by doing so, we can satisfy the requirements of the accrual concept, which says revenue should be booked when it is earned and when the performance obligation/service is rendered.
It helps us to make sure that revenue is not understated and is completely recorded.
Revenue Recognition Principle Vs Matching Principle
Have you ever wondered about what is revenue recognition principle? How does it work? And how matching principle works? If yes, then just read ahead and all your queries will go away.
Matching principle that revenue and any related expenses should be recorded in the same reporting period; this would make it easy to understand how much profit was made on the sale of any particular product or how much money the company made on running and completing any project.
On the other hand, when it comes revenue recognition principle, it focuses on the recognition of revenue when it is earned and when the recognition criteria are met as outlined in IFRS 16.
Moreover, sometimes management needs to accumulate the data of revenue and relevant expenses to make calculations for management decision purposes to see which project or product is viable to produce and which one should stop producing.
- Under the revenue recognition principle, revenue is recognized when it’s earned, not when cash is received.
- The revenue recognition principle is part of the accrual accounting system.
- Under cash basis accounting, there is no concept of deferred or accrued revenue- which means no concept for principle as well.
- Accounting Standards Codification (ASC) 606 provides a new framework of guidelines to recognize revenue.
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Hira Aziz - Author
She is a Business Content writer and Management contributor at 12Manage.com, where she contributes a business article weekly. She has over 2 years of experience in writing about accounting, finance, and business.