FAQ: What Is the Revenue Recognition Principle in Accounting?
By Indeed Editorial Team
Published September 15, 2021
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
In accounting, companies refer to the generally accepted accounting principles to determine whether they can recognize revenue for an accounting period. The revenue recognition principle is one accounting principle that outlines the criteria for recording earned revenue. There are several key considerations to make when satisfying the revenue principle to ensure you record accounting activities accurately. In this article, we discuss what the revenue recognition principle is, what the Accounting Standards Codification is and how revenue recognition should satisfy and comply with the generally accepted accounting principles.
What is revenue recognition?
Revenue recognition refers to a generally accepted accounting principle (GAAP) that outlines the criteria for realizing and accounting for revenue during specific accounting periods. Typically, these accounting periods encompass annual and interim periods. In accrual accounting, revenue recognition dictates that revenue records as businesses earn it, rather than when they actually receive payment for the transaction. This differs from the cash accounting method, which only tracks revenue as companies receive actual payments. Even though the revenue recognition principle outlines standards for accrual accounting, it doesn't change even when businesses use the cash basis of accounting.
What is the revenue recognition principle?
The revenue recognition principle states that revenue is recognizable when companies meet certain milestones or during specific accounting periods. In accrual accounting, you recognize revenue when you complete a transaction and not when you receive payment for the transaction. For example, if your company charges $100 per subscription service and collects payments 30 days later, you can recognize the revenue when customers sign up for subscriptions rather than when the company receives payment later. In cases like this example, the GAAP provides criteria for you to meet in order to recognize this income as revenue for the related period.
What is the Accounting Standards Codification?
The Accounting Standards Codification is an authoritative source for all nongovernmental generally accepted accounting principles (GAAP). The Codification encompasses both the United States Securities and Exchange Commission (SEC) resources and GAAP accountants and financial professionals rely on to document and report financial activities.
The Financial Accounting Standards Board (FASB) maintains the Codification, introducing a more understandable structure and accessible online resource system. One benefit of the Accounting Standards Codification is that it reduces the time it takes for financial professionals to research accounting topics, statutes and standards when completing accounting processes. The Codification also provides accurate information through continuous updates when GAAP introduces new standards.
Related: What Are Accounting Principles?
How does GAAP mandate the accounting of revenue?
GAAP recognizes revenue when the income companies earn meets specific conditions. Financial professionals follow the double-entry method for accounting when recognizing revenue, and the GAAP outlines the following conditions for recognizing revenue:
Credit agreements between businesses and customers
When companies extend credit to customers, timelines to receive payment occur in 30-, 60- or 90-day increments. However, this condition recognizes revenue when businesses complete transactions, as the contract terms outline when a company is to receive the cash payment. Revenue recognition then accounts for the invoice, and companies adjust these balances when accounts receivable collects on credit invoices.
Completed product or service agreements
When customers purchase products or services from a company, GAAP recognizes this revenue when the items ship or deliver and when a business completes a service. The condition outlines when revenue recognition is appropriate. This means you recognize the revenue your organization earns as customers receive product shipments or as providers fulfill their service contracts.
Established product prices
When a company establishes product or service prices, this means it has determined the cost of production and the margin necessary for generating revenue. When businesses provide products and services to customers, they finalize all related prices. This means that each price represents a revenue source, resulting in revenue recognition when businesses make products and services available for sale.
This condition outlines that revenue is recognizable when companies issue a bill of sale when completing transactions. Similar to recognizing revenue for net period contracts, collectible billing recognizes revenue when you record and send credit invoices. Businesses that offer credit terms to customers set a date for future payments, although these payment periods can be according to the company and client's schedule preferences.
Recognizing payments in advance
GAAP also states if a company receives payment in advance for a product or service, this revenue is recognizable for the accounting period. For example, assume a landscaping company provides services for $250 per month. If a client pays for the next month in advance, the company can recognize the total $500 as revenue for the accounting period.
Related: 10 GAAP Guidelines
How can you satisfy the revenue recognition principle?
GAAP recognizes revenue in several steps, which accountants use when recording revenue:
1. Determine the type of business and client contract
Understanding the type of business contract your company establishes with clients is essential in determining whether GAAP recognizes the generated revenue from contract transactions. You can refer to the GAAP criteria for identifying whether the contract type includes revenue that is recognizable for the accounting period. Additionally, both the customer and business should agree to the contract terms.
2. Ensure compliance with all contract requirements
Once you understand the contract type, check whether it meets GAAP outlines for performance standards. This means that customers must meet all obligations that sales contracts outline before a company can recognize the revenue from the transaction. For instance, if an HVAC service contract outlines that a provider must perform a diagnostic check, system cleaning and the specific contract job, there are three separate performance conditions that the provider must meet in order to recognize the revenue they earn from the service call.
3. Document the product or service cost
The price for the product or service must also be final. This means that once a business sets its product or service prices, it can recognize earned revenue when customers purchase the items. This step satisfies the recognition principle because it accounts for fixed-price items. Companies account for revenue as transactions occur, whether on a credit or cash basis, as product and services prices shouldn't vary.
4. Compare the price to the contract performance standards
When a business meets both performance and price standards to comply with contract obligations, it can recognize the revenue relating to each performance condition. For instance, a subscription service provider offers one free month of service to new customers. By giving customers one free month of service, the provider is fulfilling two separate performance conditions. The provider is first meeting the free service month obligation then meeting its service obligations. While new customers aren't paying for their first month of service, the company only recognizes the revenue from the second month after it fulfills its service offering.
5. Recognize company revenue when income meets GAAP conditions
When evaluating the conditions of product and service contracts, ensure these criteria satisfy the GAAP conditions for revenue recognition. Once a business meets all performance conditions that it establishes in contracts with customers, it can account for all earned revenue as customers finalize transactions. This means that once a company delivers a product, bills an invoice or extends a credit contract, it can recognize the revenue prior to receiving payment. When a service provider fulfills all obligations it outlines in its service contracts, it can record the revenue associated with each service transaction.
Please note that none of the companies mentioned in this article are affiliated with Indeed.
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