Revenue recognition principle
/What is Revenue Recognition?
Revenue recognition is the conditions under which an organization can recognize a sale transaction as revenue. The intent of revenue recognition is to do so in a manner that reasonably depicts the transfer of goods or services to customers, for which consideration is paid that reflects the amount to which the seller expects to be entitled. This is a key area of accounting, since business owners routinely attempt to accelerate the recognition of revenue in order to show better corporate performance than is really the case.
What is the Revenue Recognition Principle?
The revenue recognition principle states that you should only record revenue when it has been earned, not when the related cash is collected. For example, a snow plowing service completes the plowing of a company's parking lot for its standard fee of $100. It can recognize the revenue immediately upon completion of the plowing, even if it does not expect payment from the customer for several weeks. This concept is incorporated into the accrual basis of accounting.
A variation on the example is when the same snow plowing service is paid $1,000 in advance to plow a customer's parking lot over a four-month period. In this case, the service should recognize an increment of the advance payment in each of the four months covered by the agreement, to reflect the pace at which it is earning the payment.
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Accounting for Revenue Recognition
If there is doubt in regard to whether payment will be received from a customer, then the seller should recognize an allowance for doubtful accounts in the amount by which it is expected that the customer will renege on its payment. If there is substantial doubt that any payment will be received, then the company should not recognize any revenue until a payment has been received.
Also under the accrual basis of accounting, if an entity receives payment in advance from a customer, then the entity records this payment as a liability, not as revenue. Only after it has completed all work under the arrangement with the customer can it recognize the payment as revenue.
Under the cash basis of accounting, you should record revenue when a cash payment has been received. For example, using the preceding scenario, the snow plowing service will not recognize revenue until it has received payment from its customer, even though this may be a number of weeks after the plowing service completes all work.
Accounting for Revenue in Complex Situations
In many industries, there are so many events associated with the revenue recognition process that it can be difficult to establish exactly when revenue should be recognized. Under generally accepted accounting principles, there is a five-step process for establishing revenue recognition, which applies to nearly all industries. Those steps are noted below.
Step 1: Link the Contract with a Specific Customer
The contract is used as a central aspect of revenue recognition, because revenue recognition is closely associated with it. In many instances, revenue is recognized at multiple points in time over the duration of a contract, so linking contracts with revenue recognition provides a reasonable framework for establishing the timing and amounts of revenue recognition.
Step 2: Note Contractual Performance Obligations
A performance obligation is essentially the unit of account for the goods or services contractually promised to a customer. The performance obligations in the contract must be clearly identified. This is of considerable importance in recognizing revenue, since revenue is considered to be recognizable when goods or services are transferred to the customer.
Step 3. Determine the Price of the Transaction
This step involves the determination of the transaction price built into the contract. The transaction price is the amount of consideration to be paid by the customer in exchange for its receipt of goods or services. The terms of some contracts may result in a price that can vary, depending on the circumstances. For example, there may be discounts, rebates, penalties, or performance bonuses in the contract. Or, the customer may have a reasonable expectation that the seller will offer a price concession, based on the seller’s customary business practices, policies, or statements. If so, set the transaction price based on either the most likely amount or the probability-weighted expected value, using whichever method yields that amount of consideration most likely to be paid.
Step 4. Match the Price to Performance Obligations
Once the performance obligations and transaction prices associated with a contract have been identified, the next step is to allocate the transaction prices to the obligations. The basic rule is to allocate that price to a performance obligation that best reflects that amount of consideration to which the seller expects to be entitled when it satisfies each performance obligation.
Step 5. Recognize Revenue as Obligations are Fulfilled
Revenue is to be recognized as goods or services are transferred to the customer. This transference is considered to occur when the customer gains control over the good or service. Indicators that obligations have been fulfilled include when the seller has the right to receive payment, when the customer has legal title to the transferred asset, and when the customer accepts the asset. Other indicators are when possession of the asset has been transferred by the seller, and when the customer has taken on the significant risks and rewards of ownership related to the asset transferred by the seller.
Terms Similar to the Revenue Recognition Principle
The revenue recognition principle is also known as the revenue recognition concept.