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.
Overview: What is the revenue recognition principle?
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.
Requirements for revenue recognition
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:
- An arrangement or agreement is in place between your business and your customer. What this means is that you have offered credit terms to your customer, and they have agreed to pay the invoice in the amount of time in order to fulfill those terms. For instance, you provide consulting services to Client A, with credit terms of Net 30. If Client A accepts those terms, they agree to pay your invoice within 30 days of the date of the invoice.
- The product or service that you are selling has been delivered or completed. This is one of the most important components of the revenue recognition principle, which is that revenue is recognized and recorded when services are rendered or the product delivered. In essence, this means that your portion of the agreement is complete.
- The cost has been determined. When you offer your services or sell products to clients, you must provide them with the cost of those services or products, with the cost finalized prior to recognizing the revenue.
- The amount billed is collectible. This is fairly straightforward and speaks to the importance of accurately vetting clients to determine their creditworthiness. Before you offer credit terms to clients, you should be reasonably sure that you can collect the balance due from them at a future date. This is not foolproof of course, because even properly vetted companies can pay their bills late at times, but this should be the exception, not the rule.
- If you have doubts about the collectability of an invoice, it should not be recognized as revenue. This is a tough one, since it’s unlikely that you will extend credit terms to a customer that you don’t think will be able to pay their bill. However, if this issue does arise, you should delay recognizing the revenue until the bill has been paid.
- If payment is received in advance of products or services, the revenue should be recognized only after services are rendered. For instance, if your business provides office cleaning services for $500 a month, and your customer pays you $1,500 for the next three months, the revenue would be recognized at $500 for the next three accounting cycles, rather than being recognized in total for the current accounting cycle.
What does the revenue recognition principle mean for businesses?
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.
Example of the revenue recognition principle
Here are two simple revenue recognition examples:
- Your business provides tax services for a client. Once their tax return has been completed, you forward a copy of your invoice to your client, who has agreed to pay the bill within the next 30 days (net 30). You can recognize the revenue immediately, since the services have already been delivered.
- You provide monthly accounting services for your client. That client pays you in advance for the entire year, with payment received January 2 for the entire year. Remember, you can only recognize revenue as it’s earned, so while you can recognize earned revenue for January, you will have to wait until February in order to recognize February’s revenue, with revenue recognized each month through December, as services are rendered.
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.
Why understanding the revenue recognition principle is important
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.
Alert: highest cash back card we've seen now has 0% intro APR until 2025
If you're using the wrong credit or debit card, it could be costing you serious money. Our experts love this top pick, which features a 0% intro APR for 15 months, an insane cash back rate of up to 5%, and all somehow for no annual fee.
In fact, this card is so good that our experts even use it personally. Click here to read our full review for free and apply in just 2 minutes.
Our Research 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 does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.
The Ascent is a Motley Fool service that rates and reviews essential products for your everyday money matters.
Copyright © 2018 - 2023 The Ascent. All rights reserved.