What is Revenue Recognition ?

Revenue Recognition:

Revenue Recognition principle is one of the important principles of Accrual Accounting. According to this principle, revenue must be recognized when

(1) They are realized or realizable and

(2) They are earned

Revenue is realized when products are exchanged for cash or claims to cash (Receivable).

Revenue is realizable when related assets received are readily convertible to cash or claims to cash.

Revenue is earned when the products are delivered or services are performed.

Recognizing the revenue means recording the amount as revenue in the financial statements.

Realization is the process of converting non-cash resources into cash.

In the Revenue Recognition principle, it does not matter when cash is received. (In Cash Basis Accounting, revenue is recognized when cash is received no matter when goods or services are sold).

For revenue to be recognized, both the above conditions must be met. In other words for revenue to be recognized, final delivery must be completed (of goods or services) and there has to be a payment assurance.

Let us have a look at the timing of Revenue Recognition

1) For sale of finished goods (Inventory Items), revenue is recognized at the date of sale (some interpret this as the date of shipping or the date of delivery)

2) For sale of services (e.g. support services), revenue is recognized when the services are performed (delivered)

3) For sale of Asset Items (other than inventory items like finished goods), revenue is recognized at the point of sale (i.e. when the customer is invoiced)

4) For revenue from other activities like rent for using company’s Fixed Assets, revenue is recognized as time passes or as assets are used.

Examples:

1) If a company invoices its customer for 100 units of item ‘A’, and ships (delivers) only 25 units, the company cannot recognize revenue for entire 100 items. It can only recognize revenue equivalent to the number of units delivered (Revenue is earned only when the products are delivered). Similarly, let’s say you pay $120 in advance to company ‘ABC’ for magazine subscription for one full year. The fact that company ‘ABC’ received money for one full year does not mean that they can record the entire amount as Revenue. In-fact the amount received in advance is a Liability to the company because they have to deliver magazines to their customer every month and if they fail to do so, they are liable to refund the amount received in advance. In this scenario, the company will recognize 1/12th of the entire amount every month as earned revenue after they deliver the magazine.

2) Company ‘ZXC’ signs a 3 year support contract with its client for a total amount of 3 million. This amount cannot be recorded as revenue unless the Company provides the support services to the client. Assuming the company is following a monthly calendar accounting period, the company will recognize 1/36th of the entire support contract deal amount every month. (Revenue is recognized when services are performed)

There are few exceptions to the timing of revenue recognition for sale of inventory items. Under normal scenario, revenue is recognizes at the point of sale, however if there are return policies, and if the company cannot reasonably estimate the amount of future returns, the revenue should be recognized only after the expiration of the return policy period.

Revenue Recognition Accounting:

If revenue is not recognized immediately, what is the accounting entry for the Sales Invoice? Let’s have a look

Let’s say, you invoice the Customer in Advance for the annual support contract of $12000. Since, you are invoicing the customer in Advance, you debit your Receivables. But then if you are not crediting the revenue right away, where do you account for the credit side of the accounting entry? You credit, what is called as Deferred Revenue (or Unearned Revenue). Deferred Revenue is actually a liability for the company. (The company is liable to provide the goods or services for which cash is received or will be received in advance). As and when the goods or services are delivered, the Deferred Revenue is reduced (debited) and revenue is recognized.

Accounting when the Invoice is created in Jan

Date	Accounting Class	Debit	Credit	Comments
1-Jan	Receivables	12000		The entire receivables is recognized in advance. How this receivable is collected will depend on the payment terms of the Invoice
1-Jan	Deferred Revenue		12000

End of Jan, Revenue is recognized for 1/12th of the entire amount, because the company has provided one month’s service to its client. To that effect, Deferred Revenue will be reduced and revenue will be recognized

Date	Accounting Class	Debit	Credit	Comments
31-Jan	Deferred Revenue	1000		Deferred Revenue reduced
31-Jan	Earned Revenue		1000	Earned Revenue amount for one month

End of Feb, another months revenue is recognized

Date	Accounting Class	Debit	Credit	Comments
28-Feb	Deferred Revenue	1000		Deferred Revenue reduced
28-Feb	Earned Revenue		1000	Earned Revenue amount for one month

The company will have similar accounting entry each month till Dec. At the end of Dec, the Deferred Revenue will be Zero and the entire amount will be reported as Revenue earned.