Revenue Recognition Principle

Before we proceed towards discussing the revenue recognition principle, let's first conduct a brief discussion of the two accounting bases - trust, me, it's relevant. Pecuniary transactions may be recorded under either the cash basis or accrual basis of accounting. Under the cash basis, only those transactions for which actual cash (real time receipts of payment which may be in terms of cash or check) has been exchanged in the given accounting period are recorded as income or expenditure for that particular accounting period. Under the accrual basis of accounting, all such transactions for which any income is earned (whether or not actually received) or any expense is incurred (whether or not actual payment is made) in a given accounting period is recorded as an income or expenditure for that particular period.

Now, coming back to the principle of revenue recognition, which is also included among the Generally Accepted Accounting Principles (GAAP), it is an important component of the accrual basis of accounting, as under this basis and as per this principle, revenue is identified for the accounting period and any advance revenue receipt is differentiated for that accounting period to which it accrues. Confused? Well, read ahead to get more clarity.

Definition of the Principle of Revenue Recognition

Nowadays, not all transactions are fulfilled on delivery-on-cash basis. Most of the time, the goods and services are delivered first and the payment is made at a later date, or maybe even in several installments. However, irrespective of whether the entire payment is received within the given accounting period, such a revenue is definitely earned and belongs to that particular accounting period and as such, needs to reflect in the book of accounts for that period. Contrarily, even if an advance payment is received for goods that are to be delivered in some future accounting period, such revenue is not included in the accounts of the present accounting period as they are earned for a future time and, as such, accrue to that accounting period.

In conformity with this fundamental accounting logic, revenue is differentiated as accrued and deferred. Accrued revenue is when goods are delivered or services are rendered and revenue is earned but not yet received. Deferred revenue is when revenue is received but it is not yet earned since the goods/ services are delivered/ rendered at some future date. The revenue recognition principle (GAAP recognized) can be better understood from the following example:-

Q - ABC & Sons signed a contract with Messrs XYZ on 15th December, 2010, to deliver 10,000 units of cement to the latter on 25th January, 2011. The price quoted by ABC & Sons was $30,000 and Messrs XYZ agreed to pay 50% on the spot and the rest on delivery. In accordance with this agreement, Messrs XYZ paid $ 15,000 in advance. However, While taking delivery on 25th January, 2011, Messrs XYZ cited some financial difficulty and paid only $8,000, promising to pay the remaining $ 7,000 on 3rd April, 2011. Assuming the accounting period followed by ABC & Sons to be 12 months from 1st April to 31st March, how will the above revenues reflect in their books?

A - Delivery is made on 25th January, 2011, making that the day when the revenue is earned and recognized. The entire amount of $ 30,000 will be recorded as revenue for the accounting period of 1st April 2010 - 31st March 2011. It may be broken up into two parts though - a combined amount of $23,000 ($15,000 + $8,000) will be narrated as revenue received and the balance amount of $7,000 will be narrated as outstanding revenue.

Revenue Recognition Principle and Matching Principle

The matching principle of accounting, one of the basic accounting principles and concepts, seeks to match the expenses and revenues with the accounting periods in which they are incurred or earned. As such, it is a conclusive principle that combines all aspects of the accrual basis of accounting and the revenue recognition principle. Importance of the matching principle lies in the fact that earnings can be traced back to the exact accounting period irrespective of whether the revenue is pre received or outstanding. In case of pre-receipt, the real earning status is not lost and true earning period is not distorted. In case of accruals, a record is present of the actual earnings and collectible amounts. If accounting is done on cash basis, keeping track of such issues may require extra efforts and resources but the accrual basis and its two instrumental principals make sure that these untimely revenue issues reflect in the master account itself.

However, there a few exceptions to the principle of revenue recognition. In case of long-term contracts such as construction, mining, etc., the billing is permitted at various points of the contract period and it is not necessary for the contractor to wait till the completion of the contract and transfer of ownership. Also, contracts involving buy-back agreements and future returns do not follow this principle because these cannot be clearly identified as actual sales. Hope that helped!