The revenue recognition principle states that revenue should be recognized and recorded when it is realized or realizable and when it is earned. In other words, companies shouldn’t wait until revenue is actually collected to record it in their books. Revenue should be recorded when the business has earned the revenue. This is a key concept in the accrual basis of accounting because revenue can be recorded without actually being received.
Revenues are realized or realizable when a company exchanges goods or services for cash or other assets. So if a company enters into a transaction to sell inventory to a customer, the revenue is realizable. A specific amount of cash is identified in the transaction. The revenue is not recorded, however, until it is earned. In this case, the retailer would not earn the revenue until it transfers the ownership of the inventory to the customer.
There are three main exceptions to the revenue recognition principle. Some manufacturers may recognize revenue during the production process. This is common in long-term construction and defense contracts that take years to complete. The revenue in these cases is considered earned at various stages of job completion.
Some companies recognize revenue after the manufacturing process but before the sale actually takes place. Mining, oil, and agricultural companies use this system because the goods are marketable and effectively sold as soon as they are mined.
The last exception to the revenue recognition principle is companies that recognize revenue when the cash is actually received. This is a form of cash basis accounting and is most commonly found in installment sales.
– Bob’s Billiards, Inc. sells a pool table to bar on December 31 for $5,000. The pool table was not paid for until January 15th and it was not delivered to the bar until January 31. According to the revenue recognition principle, Bob’s should not record the sale in December. Even though the sale was realizable in that the sale for $5,000 was initiated, it was not earned until January when the pool table was delivered.
– Johnson and Waldorf, LLC is an accounting firm that provides tax and consulting work. During December, JW provides $2,000 of consulting work to one of its clients. The client does not pay for the consulting time until the following January. According to the revenue recognition principle, JW should record the revenue in December because the revenue was realized and earned in December even though it was not received until January.
– Pat’s Retail, Inc. sells clothing from its retail outlets. A customer purchases a shirt on June 15th and pays for it on a credit card. Pat’s processes the credit card but does not actually receive the cash until July. The credit card purchase is treated the same as cash because it is a claim to cash, so the revenue should be recorded in June when it was realized and earned.