If you're on a Galaxy Fold, consider unfolding your phone or viewing it in full screen to best optimize your experience.
If your business uses accrual accounting, you should know and understand the revenue recognition principle, sometimes known as the revenue principle.
Why not take a few minutes and learn more about the revenue recognition principle and why it is important to your business.
No matter what type of accounting your business is using, the revenue recognition principle remains the same.
The revenue recognition principle says that revenue should be recorded when it has been earned, not received. The revenue recognition concept is part of accrual accounting, meaning that when you create an invoice for your customer for goods or services, the amount of that invoice is recorded as revenue at that point, and not when the money is received from the customer.
This is one of the major differences between accrual basis accounting and cash basis accounting, since with cash accounting, revenue is recognized when payment is received, not when it’s earned.
The revenue recognition principle requires that you use double-entry accounting. Here are some additional guidelines that need to be followed in regards to the revenue recognition principle:
The revenue recognition principle enables your business to show profit and loss accurately, since you will be recording revenue when it is earned, not when it is received.
Using the revenue recognition principle also helps with financial projections; allowing your business to more accurately project future revenues. Recognizing revenue properly is also important for businesses that receive payment in advance of services, such as businesses that provide service contracts that require payment up front.
In order to recognize revenue properly, any business that receives payment upfront for services to be rendered must recognize that revenue only after the services have been performed. For instance, if you offer a yearly support contract to your customers for $12,000 annually, you would recognize revenue in the amount of $1,000 monthly for the next 12 months.
Date | Account Name & Description | Debit | Credit |
---|---|---|---|
1/1/2020 | Cash - To record prepayment | $12,000 | |
1/1/2020 | Client Prepayment - To record prepayment | $12,000 |
Date | Account Name & Description | Debit | Credit |
---|---|---|---|
1/31/2020 | Client Prepayment - Record January payment | $1,000 | |
1/31/2020 | Account Services Income - Payment for January | $1,000 |
In Example 1, you would debit your cash account, since the money will be deposited. However, instead of applying it to an income account, you would place it in a Client Prepayment account, which will be gradually reduced until the complete $12,000 has been earned.
In Example 2, you would debit the Client Prepayment account, since you are reducing the balance by $1,000, while crediting your income account for the month of January, continuing to do a journal entry each month through the month of December in order to properly account for the earned revenue.
Here are two simple revenue recognition examples:
If you’re a sole proprietor operating on a cash basis, chances are that using the revenue recognition principle is not necessary. However, if your business operates on an accrual basis, and you wish to use accounting ratios such as the accounts receivable turnover ratio, it’s a good idea for you to understand and use the revenue recognition principle in order to ensure that your business is recording and reporting revenue properly.
It’s important that during the bookkeeping and accounting process, that you recognize revenue only after goods or services have been provided. As the examples above have shown, if your customer pays for an annual service contract, the revenue from that contract must be recognized as it’s earned, not when it’s received.
If you’re using accrual accounting for your business, it’s vital that you understand the revenue recognition principle properly. Using this principle will ensure that you are producing accurate financial statements in real time. Using this principle also helps you better account for revenue in the period that it’s earned, rather than the period in which it’s received.
In order to produce accurate financial statements, it’s important to understand and properly use the revenue recognition principle. Using this principle allows you to record your revenue as it’s earned, thus providing a more accurate profit and loss statement, a must if you’re looking for investors or business financing.
If you’re currently in the market for small business accounting software that will help you better track revenue, be sure to check out The Ascent’s accounting reviews.
Our Small Business Expert
We're firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. The Ascent, a Motley Fool service, does not cover all offers on the market. The Ascent has a dedicated team of editors and analysts focused on personal finance, and they follow the same set of publishing standards and editorial integrity while maintaining professional separation from the analysts and editors on other Motley Fool brands.