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Revenue recognition is an accounting term that seems like it should be pretty self-explanatory. Surprisingly, recognizing revenue is much more complicated than the name would suggest. Generally Accepted Accounting Principles (GAAP) explain the specific conditions that must be met before a business can recognize revenue. Following is a basic explanation of how GAAP recognizes revenue.
Why Rules Regarding Revenue Accounting Are Important
Revenue is one way businesses measure success. There is huge incentive for businesses to recognize revenue as soon as they can, every chance they can. Without GAAP rules, businesses could easily overstate revenue and mislead investors as to how successful their business actually is.
Revenue Recognized When Accrued
Accrual accounting allows businesses to recognize revenue when it is earned instead of physically received. The principle behind accrual accounting is to match revenue and the expenses necessary to earn that revenue (Matching Principle of Accounting). For example:
– Company A provided their services to Company B in month #1
– Company A sent a invoice to Company B at the end of month #1 payable in 30 days
– Company B received the invoice in month #2 and paid it 30 days later at the end of month #2
– Company A received the actual payment in month #3
Accrual accounting dictates that Company A must recognize the revenue in month #1 as opposed to month #2 when Company B paid the bill or month #3 when Company A actually received the payment.
Conditions to Recognizing Revenue
Before a transaction can be accounted for as “revenue”, there are several conditions that must be met.
– Actual evidence of an agreement must exist. A major banking entity recently got in trouble because they opened accounts in their customer’s names without their authorization. If they recognized revenue on these transaction, that would be a violation of GAAP standards because an agreement did not exist for the transaction.
– Delivery of goods or services must have taken place. Companies that provide a full year of services for one set fee must allocated a portion of that fee each month as they provide the service. The revenue is not actually earned until the service has been provided.
– The price must be fixed and determinable. The price itself must be agreed upon and can not change over time. In addition it has to be such that it can be verified by an independent auditor if necessary.
– Collection of the actual payment must be (reasonably) guaranteed. To be considered revenue, there has to be a reasonable certainty that the payment will be made. If for some reason the payment is never made, this amount has to be reversed back out of revenue.
Cash Basis Accounting
Some companies can use a cash basis for their accounting records. This means that they recognize revenue when it is received, not earned. Small sole proprietors and companies with no inventory could choose to use this type of accounting.
Summary
Revenue recognition is actually more complicated than this basic explanation. The rules for revenue recognition are actually changing over to a more principle-based approach to revenue accounting instead of industry specific accounting practices. These new rules should make accounting for revenue more understandable.