When to recognize revenue

What is Revenue Recognition?

Revenue recognition is the process of deciding when to record revenue as the result of a sale transaction. This typically occurs after you have proven that a contract exists between you and the customer, that all performance obligations stated in the contract have been fulfilled, and that you can measure the dollar amount of the sale. A performance obligation typically involves the delivery of some type of good or service to the customer.

Why is Revenue Recognition Important?

There are multiple reasons why revenue recognition is important. The following are key factors to consider:

  • Enhanced reporting accuracy. Proper revenue recognition improves the accuracy of the income statement, so that revenue is recognized only when earned.

  • Better performance reporting. Management has a better understanding of the performance of a business when its revenue is properly recognized within the correct reporting period.

  • Increased investor confidence. When a business recognizes revenue properly, this improves investor confidence in the organization, which makes them more likely to invest funds in it or loan funds to it. This can result in a higher stock price, if the entity is publicly-held.

  • Fraud avoidance. Proper revenue recognition reduces the risk of reporting fraud, which might otherwise be used to mislead investors regarding the revenue generating capacity of a business.

  • Regulatory compliance. Proper revenue recognition ensures that a business complies with the reporting requirements of the applicable government agency, so it is less likely to be fined for incorrect reporting.

Revenue Recognition in Accrual Basis Accounting

The criteria just noted for revenue recognition are required for accrual basis accounting, where revenue is recognized once it has been earned. This differs from revenue recognition under the cash basis of accounting, where revenue is recognized when cash is received from the customer. Thus, the recognition of revenue under the accrual basis of accounting does not necessarily coincide with the receipt of a customer’s payment.

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Criteria for Revenue Recognition

More specifically, an entity can record revenue when it meets all of the following criteria:

  • The price is substantially fixed at the sale date.

  • The buyer has either paid the seller or is obligated to make such payment. The payment is not contingent upon the buyer reselling the product.

  • The buyer’s obligation to pay does not change if the product is destroyed or damaged.

  • The buyer has economic substance apart from the seller.

  • The seller does not have any significant additional performance obligations related to the sale.

  • The seller can reasonably estimate the amount of future returns.

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